THE  LIBRARY 

OF 

THE  UNIVERSITY 

OF  CALIFORNIA 

RIVERSIDE 


GIFT  OF 

Dr.  Gordon  Vatkins 


<J&&        $  X 

A~4stfi* 


'j.4<t''- 


PRINCIPLES  OF 
ECONOMICS 


By 


F.  M.  TAYLOR,  PH.D. 

Professor  of  Economics  in  the 
University  of  Michigan 


EIGHTH  EDITION 
Second  Printing 


NEW  YORK 

THE  RONALD  PRESS  COMPANY 

1921 


Copyright,  1921,  by 
THE  RONALD  PRESS  COMPANY 


Att  Rights  Reserved 


PREFACE 

It  is  hardly  necessary  to  say  that  this  book  is  intended  only  for 
use  as  a  textbook.  There  is  perhaps  more  need  to  explain  that  it 
does  not  cover  quite  the  same  ground  as  the  conventional  type  of 
such  books.  First,  it  contains  less  descriptive  matter  than  is  com- 
monly offered.  As  this  perhaps  assumes  more  knowledge  of  eco- 
nomic phenomena  than  the  average  student  in  elementary  economics 
possesses,  it  may  be  desirable  to  use  along  with  this  text,  especially 
in  the  early  stages  of  the  course,  some  book  on  economic  organization. 
At  Ann  Arbor  we  have  been  trying  this  plan  during  the  current 
semester  and  expect  to  continue  doing  so  next  year. 

But  this  book  not  only  starts  at  a  point  somewhat  later  than 
the  conventional  textbook,  it  also  stops  at  an  earlier  point.  More 
specifically  it  stops  short  of  any  serious  study  of  practical  problems 
such  as  the  Tariff,  Business  Cycles,  and  Labor  Legislation.  In  so 
far  as  such  problems  receive  any  comment  at  all,  this  occurs  in  the 
process  of  illustrating  economic  principles, — no  attempt  being  made 
to  pass  judgment  on  such  problems  taken  as  a  whole.  In  short,  this 
book  is  not  intended  to  be  a  general  treatise,  the  mastery  of  which 
will  give  the  student  a  fairly  adequate  knowledge  of  the  whole 
economic  field.  Instead,  it  is  intended  to  perform  just  one  special 
function  in  the  student's  economic  education,  namely,  helping  him  to 
master  the  body  of  principles,  mostly  quite  abstract,  which  are 
generally  held  by  economic  authorities. 

I  have  noted  that  this  textbook  is  designed  to  perform  a  nar- 
rower function  than  is  usually  undertaken  by  such  books.  It  may 
be  well  to  add  that  it  also  differs  from  most  others  in  that  it  lays 
more  stress  on  securing  for  the  student  a  very  definite  mastery  of 
the  accepted  body  of  economic  principles, — such  mastery  as  the 
student  of  Chemistry  or  Physics  is  expected  to  acquire.  This  will 
explain  the  rather  rigid  methods  of  statement,  the  presentation  of 


IV  PREFACE 

principles  in  formal  shape,  and  the  extensive  use  of  problems  or 
examples  which  the  student  is  expected  to  work  out. 

In  view  of  the  air  of  finality  given  by  the  method  of  presenta- 
tion just  remarked  upon,  it  seems  almost  necessary  to  explain  that 
this  book  has  no  real  finality  in  the  mind  or  purpose  of  the  author. 
In  fact,  it  is  only  a  book  in  the  making.  It  has  been  revised  almost 
every  year  since  it  was  first  brought  out  in  a  series  of  separate 
leaflets  fifteen  or  sixteen  years  ago;  and  the  contract  with  the  pres- 
ent publisher  provides  for  a  continuation  of  that  policy.  This  does 
not  mean  that  the  author  considers  such  a  procedure  requisite  in 
order  to  keep  up  with  fundamental  changes  in  economic  doctrine, 
but  merely  that,  in  working  out  his  plan,  he  seems  to  find  it  neces- 
sary to  resort  to  the  method  of  trial  and  error.  Each  edition, 
therefore,  contains  experiments  in  analysis  and  presentation  which 
are  expected  to  show  a  need  for  revision  and  to  get  such  revision  in 
later  editions.  The  necessity  for  this  procedure  is  diminishing;  but 
it  has  by  no  means  disappeared.  I  expect,  therefore,  to  continue  the 
policy  indicated  for  some  time  to  come. 

A  cursory  reading  of  this  book  will  show  that  it  makes  little  or 
no  claim  to  originality  in  substance.  Still,  it  would  be  quite  impos- 
sible that  any  man  who  has  taught  elementary  economics  for  thirty- 
four  years  and  advanced  courses  in  economic  theory  for  twenty-eight 
years,  should  not  secretly  cherish  the  belief  that  he  has  made  some 
trifling  modifications  in  economic  analysis  which  seem  to  partake  of 
the  nature  of  contributions.  However,  it  is  not  worth  while  to  give 
these  more  specific  comment.  If  such  modifications  are  of  any 
significance  the  fair-minded  student  will  note  the  fact;  if  not,  the 
less  said  about  them  the  better. 

If  it  had  not  already  been  sufficiently  brought  out  by  implication 
in  this  preface,  the  reader  of  the  text  would  very  soon  learn  that 
the  body  of  doctrine  herein  contained  is,  on  the  whole,  rather  mark- 
edly orthodox.  I  should  have  been  sorry  to  be  obliged  to  make  it 
otherwise;  for  I  should  have  been  sorry  to  believe  that  our  prede- 
cessors have  left  no  body  of  doctrine  which  is  to  abide  for  an 
indefinite  period  in  the  future.  I  have  been  at  some  pains,  how- 
ever, to  stress  the  point  that  the  acceptance  of  orthodox  economic 
doctrine  is  entirely  compatible  with  giving  support  to  whatever 


PREFACE  V 

degree  of  interference  with  the  working  of  the  present  economic 
order  may  prove  on  the  whole  conducive  to  the  welfare  of  society. 

It  is  not  my  intention  to  enumerate  the  particular  persons  who  in 
one  way  or  another  have  contributed  to  the  preparation  of  this  text, 
chiefly,  perhaps,  because  the  list  would  be  too  long.  In  general  I  feel 
that  I  owe  most  to  the  small  army  of  young  men  who  in  the  course 
of  the  last  fifteen  years  have  assisted  in  teaching  it  at  this  university. 
From  them  I  have  received  many  useful  criticisms  and  many  valu- 
able suggestions.  The  only  person  whose  hand  is  largely  shown  in 
the  present  form  of  the  book  is  Mr.  Elmer  C.  Adams — now  with  the 
Detroit  Evening  News — who  collaborated  with  me  in  the  preparation 
of  the  fifth  edition. 

The  most  important  change  in  the  present  edition  is  the  revised 
treatment  of  the  prices  of  primary  factors  presented  in  Chapters 
XXIX  and  XXX.  Minor  ones  appear  at  various  points,  particularly 
in  the  introductory  chapter  and  the  chapter  preliminary  to  the 
discussion  of  price. 


FRED  M.  TAYLOR 


Ann  Arbor,  Michigan 
July  5,  1921 


CONTENTS 


CHAPTER  PAGE 

I     Introductory I 

II  General  Survey  of  the  Existing  Economic  Order  16 

III  Authoritative  Control  in  the  Existing  Economic 

Order 36 

IV  Analysis  of  Production 46 

V    Capital  as  Capital     .           59 

VI  The  Different  Agents  in  Production    ....  81 

VII  General  Conditions  of  Productive  Efficiency     .  89 

VIII     Efficiency  of  Different  Factors 105 

IX  Increase  in  Output  and  Rate  of  Production    .      .  122 

X  Attempts  to  Increase  Output  and  Some  Economic 

Consequences 136 

XI  Increase  in  Output  and  Cost  of  Production    .      .  146 

XII     Money  Exchange 160 

XIII  Credit  Exchange 175 

XIV  Some  Money  Truisms 187 

XV     Say's  Law 196 

XVI     The  Principle  of  Reciprocity 206 

XVII     The  Law  of  Comparative  Costs 220 

XVIII  Speculative  Trading  and  Insurance     ....  227 

XIX     Value  and  Prices  Preliminary 242 

XX     Market  Demand  Schedules 253 

vii 


Vlll 


CONTENTS 


CHAPTER 

XXI 

XXII 

XXIII 

XXIV 

XXV 

XXVI 

XXVII 

XXVIII 

XXIX 

XXX 

XXXI 

XXXII 

XXXIII 

XXXIV 

XXXV 

XXXVI 

XXXVII 

XXXVIII 

XXXIX 

XL 

XLI 

XLII 

XLIII 

XLIV 


Market  Supply  Schedules 


PAGE 
268 


Principles  Governing  the  Immediate  Processes  of 

Price  Determination 278 

Limiting  Prices 289 

Normal  Demand  Schedules 298 

Normal  Supply  Schedules 311 

Principles  Governing  the  Determination  of  Nor- 
mal Price 326 

Special  Cases  of  Normal  Price 342 

The  Prices  of  Primary  Factors  and  Disutility     .  357 

The  Prices  of  Primary  Factors  and  Significance    .  364 

The  Prices  of  Primary  Factors  and  Significance 

(Continued)  372 

The  System  of  Prices  as  a  Whole 382 

Principles  Governing  the  Money  Standard     .      .  393 

Principles  Governing  the  Circulation  of  Money    .  404 

Principles  Governing  the  Movements  and  Distri- 
bution of  Money 413 

Principles  Governing  the  Value  of  Money    .      .  425 

The  Present  System  of  Distribution     ....  438 

The  General  Principle  of  Distribution :  Corollaries  447 

Rent 456 

Interest 468 

Wages 481 

Profits 493 

Critique  of  Existing  System :   Introductory    .      .  503 

Critique  of  Present  Principle  of  Distribution     .  511 

The  Property  Incomes  Indestructible    ....  524 


CONTENTS 


IX 

PAGE 


CHAPTER 

XLV     The  Property   Incomes  as   Incomes  of   Private 

Owners 530 

XLVI     Critique  of  the  Process  Whereby  Production  is 

Regulated 544 

XLVII     Critique  of  Production  in  Respect  to  Efficiency    .     554 

XLVIII     Critique  of  Consumption 560 

APPENDIX — Explanatory  Notes 563 


CHAPTER  I 

INTRODUCTORY 

Goods. — One  of  the  most  characteristic  marks  of  a  sentient 
being  like  man  is  to  have  wants, — we  might  almost  say  that  to  feel 
wants  and  secure  their  satisfaction  is  the  very  essence  of  living. 
Again,  it  is  manifest  that  the  satisfaction  of  any  want  depends  on 
the  presence  of  the  appropriate  condition.  The  satisfaction  of  phys- 
ical hunger  depends  on  having  food  at  our  disposal ;  the  satisfaction 
of  our  craving  for  affection  requires  a  certain  attitude  on  the  part  of 
some  other  person  or  persons ;  the  satisfaction  of  our  love  of  beauty 
depends  on  the  presence  of  beautiful  objects ;  and  so  on.  All  objects 
or  conditions  on  which  the  satisfying  of  wants  is  dependent,  we  shall 
call  goods,  using  the  term  very  broadly.  The  property  of  goods 
whereby  they  are  thus  able  to  satisfy  wants  we  call  their  utility. 

Economic  Goods. — But,  now,  as  students  of  economics,  we 
are  concerned,  not  with  every  kind  of  goods,  but  only  with  one  par- 
ticular kind  known  as  economic  goods.  Our  next  duty,  therefore, 
is  to  learn  something  about  the  characteristics  which  enable  us  to 
distinguish  economic  goods  from  other  goods.  Under  the  present 
economic  order,  such  a  characteristic,  and  one  very  easy  of  appli- 
cation, is  to  be  found  in  what  we  call  exchange  -value  or,  still  more 
exactly,  price.1  The  great  majority  of  those  goods  which  all  recog- 
nize as  economic  enable  their  owner  to  command  in  exchange  money 
or  other  economic  goods ;  and,  on  the  other  hand,  can  be  obtained 
by  people  who  do  not  themselves  produce  those  goods,  only  by  giving 
in  exchange  money  or  other  goods  of  the  same  general  nature. 

1  This  would  not  be  true  under  a  system  of  pure  communism  such  as 
that  which  Russia  apparently  set  out  to  establish  in  the  fall  of  1917.  Un- 
der that  system,  there  was  to  be  no  exchange,  no  selling  and  buying;  yet 
there  would  surely  be  economic  goods,  since  the  people  of  Russia  would 
continue,  in  the  main,  to  feel  the  same  wants,  and  so  to  need  the  same 
goods,  as  they  had  before  the  new  system  was  introduced. 


2  PRINCIPLES  OF  ECONOMICS  [I 

Since  we  are  mainly  concerned  with  the  economics  of  the  present 
order,  it  would  perhaps  be  just  as  well  at  this  stage  of  our  study  to 
leave  the  student  to  depend  on  this  simplest  test  of  what  is  and  what 
is  not  an  economic  good.  Experience,  however,  inclines  me  to  think 
that  considerable  advantage  would  be  gained  if  the  student  were 
to  get  at  the  very  outset  a  deeper  understanding  of  the  real  nature 
of  economic  goods.  Before  going  on,  therefore,  we  will  attempt  a 
little  more  thorough  analysis  of  this  matter. 

Economic  Goods  Conduct-Determining. — In  trying  to  find  a 
mark  of  economic  goods  which  is  more  fundamental  than  mere 
exchange  value  or  price,  we  first  note  a  characteristic  which,  though 
possessed  by  many  non-economic  goods,  after  all  shuts  out  a  con- 
siderable number  of  them,  and  is  at  the  same  time  of  very  great 
importance.  That  characteristic  may  be  designated  conduct-deter- 
mining or  conduct-conditioned.2  That  is,  goods  of  this  sort  are 
goods  which  call  on  us  for  appropriate  conduct :  we  need  to  act  in  a 
certain  way  to  get  these  goods  or  to  enjoy  them.  Thus,  we  can- 
not hope  to  possess  the  affection  of  our  friends  or  the  approval  of 
our  neighbors  unless  we  conduct  our  lives  in  a  suitable  manner, 
The  conduct-conditioned  goods  last  named  are,  of  course,  not 
economic  goods ;  but  the  statement  made  in  respect  to  them  surely 
applies  to  goods  of  the  latter  kind  also.  Thus,  we  cannot  hope 
to  have  clothing  or  food  unless  we  expend  effort  and  trouble  produc- 
ing these  things  or  producing  other  goods  to  exchange  for  them. 
Again,  having  obtained  these  goods,  we  could  not  hope  long  to  enjoy 
them  unless  we  were  willing  to  take  care  of  them,  store  them,  guard 
them  against  thieves,  protect  them  from  fire,  and  so  on.  Economic 
goods,  then,  belong  in  the  class  of  goods  which  are  conduct-deter- 
mining or  conduct -conditioned ;  and  this  is  one  of  their  most  im- 
portant characteristics. 

Economic  Goods  Have  Importance. — The  last  paragraph 
emphasized  the  point  that  the  property  of  being  conduct-determin- 


*  These  designations  are  not  quite  equivalent,  but  I  shall  take  the  liberty 
of  using  them  interchangeably,  choosing  in  each  particular  connection  the 
one  which  seems  most  suitable. 


I]  INTRODUCTORY  3 

ing,  though  not  limited  to  economic  goods,  is  one  of  the  most  im- 
portant characteristics  of  such  goods.  Another  point  needing  com- 
ment is  the  precise  reason  why  certain  types  of  goods  have  this 
property  of  being  conduct-determining.  For,  on  this  point,  there  is 
much  erroneous  opinion.  The  general  answer  to  this  question  is 
to  be  found  in  the  statement  that  goods  of  this  kind  have  importance 
for  us,  our  welfare  depends  on  them,  we  have  something  at  stake 
in  them.  But  this,  again,  needs  sharper  definition.  There  is  a  kind 
of  importance  which  is  not  conduct-determining  and  therefore  does 
not  interest  us, — is  not  a  real,  actual  importance  at  all.  The  air  we 
breathe  has  an  importance  of  this  kind.  Importance  it  has,  since 
without  it  we  die.  But,  then,  this  importance  is  one  which  does  not 
count; — from  the  practical  standpoint  it  does  not  really  exist,  just 
because  it  does  not  call  on  us  to  regulate  our  conduct  with  respect 
to  itself.  Thus,  we  do  not  need  to  see  that  we  are  provided  with 
air,  do  not  need  to  worry  about  it,  do  not  need  to  give  it  so  much  as  a 
thought ;  for  it  is  supplied  to  us  as  a  matter  of  course. 

Economic  Goods  Have  Effective  Importance. — This  contrast 
between  the  kind  of  importance  which  does  not  make  things  conduct- 
determining,  and  the  kind  of  importance  which  does,  is  sometimes 
expressed  by  saying  that  the  former  is  merely  potential  importance, 
the  latter  actual  importance.  Again,  that  contrast  is  at  times  ex- 
pressed by  saying  that  the  former  kind  of  importance  is  merely 
generic  importance,  while  the  latter  is  specific  importance.  The 
former  phrase  means  that  the  goods  in  question  have  importance  as 
a  mere  kind  of  goods ;  the  latter  means  also  that  every  unit  of  these 
goods  which  is  at  our  disposal  has  importance.  A  phrase  we  shall 
often  use  instead  of  specific  importance  is  effective  importance. 

The  point  joist  made,  we  must  emphasize  still  further  even  at 
the  risk  of  being  tiresome.  For  a  failure  to  understand  it  is  the  cause 
of  a  very  wide-spread  and  persistent  economic  error.  From  highly 
intelligent  and  often  highly  educated  people,  we  are  constantly 
hearing  talk  like  this :  "The  valuations  which  society  puts  on  things 
are  incredibly  absurd.  Things  which  serve  only  for  the  satisfying 
of  the  most  trifling  of  wants  are  esteemed  more  highly  than  things 
on  which  our  very  existence  depends.  We  rate  the  services  of  a 


[I 

professional  singer,  a  Caruso,  far  above  those  of  a  coal  miner  or 
a  farmer;  we  esteem  diamonds  infinitely  more  than  bread;  we  pay 
teachers,  who  perform  one  of  the  most  important  of  social  functions, 
less  than  the  poorest  workman  in  an  automobile  factory." 

The  answer  to  all  this  is  that  it  confuses  real,  actual,  effective 
importance  with  mere  generic  importance,  and  that  it  is  usually  3  the 
business  of  society  to  concern  itself,  not  with  the  generic  importance 
of  services  or  goods,  but  with  their  effective  importance.  To  rate 
professional  singers  as  such  more  highly  than  coal  miners  as  such 
would  of  course  be  absurd ;  and  we  may  be  quite  sure  that  very  few 
people  could  be  found  who  really  do  so.  If  we  had  to  give  up  all  the 
singers  or  all  the  miners,  we  should  without  a  second  thought  decide 
against  the  singers.  But,  under  all  ordinary  conditions,  no  such 
alternative  is  presented  to  us.  We  are  going  to  continue  to  have  both 
Carusos  and  miners :  we  are  simply  called  on  to  decide  whether  we 
need  one  more  Caruso  more  or  less  than  we  need  one  more  miner. 
From  this  standpoint,  there  is  no  room  for  any  answer  but  the  one 
people  generally  make :  Important  as  miners  are,  when  considered  as 
a  class,  one  miner  more  or  less  is  very  unimportant  as  compared 
with  one  Caruso  more  or  less.  The  real  effective  importance  of  a 
Caruso  is  much  greater  than  that  of  a  miner.  Society  is  not  acting 
foolishly  or  thoughtlessly  or  wickedly  in  acting  just  as  it  does  in 
evaluating  the  services  of  a  Caruso  far  more  highly  than  those  of  a 
miner.  On  the  contrary,  its  evaluations  at  this  point  are  just  what 
they  ought  to  be :  they  express  the  real  comparative  importances  in- 
volved. 

ILLUSTRATIVE  PROBLEMS 

i.  The  lumber  of  which  a  frame  house  is  made  has  much  more 
generic  importance  than  the  oxide  of  lead  which  enters  into  the  paint 
which  covers  the  house;  yet  a  hundred  pounds  of  lumber  has  much  less 
effective  importance  than  a  hundred  pounds  of  the  oxide  of  lead.  Ex- 
plain and  defend  both  statements. 


1  Circumstances  arise  under  which  society  is  in  danger  of  losing  some 
economic  good  altogether  or,  anyhow,  seeing  its  stock  seriously  reduced, — for 
example,  its  forests.  In  such  case,  it  must  have  regard  to  totals  as  well  as 
units. 


I]  INTRODUCTORY  $ 

2.  Rain  and  sunshine,  though  having  vast  generic  importance,  have 
no  effective  importance  as  the  phrase  is  used  in  the  text.    Defend  that 
statement. 

3.  "Alone  and  lost  in  the  desert,  his  last  morsel  of  food  and  his  last 
drop  of  water  gone,  he  would  cheerfully  have  given  his  gold,  his  yachts, 
his  palaces,  all  his  wealth,  for  the  meager  fare  of  the  day  laborer.    At 
last   the   illusions   which   he   shared  with   civilized   society   were    fully 
dispelled.    The  unutterable  folly  of  the   comparative  estimates  which 
men  commonly  put  on  things  became  manifest.     At  last,  on  the  verge  of 
oblivion,  he  saw  things  in  their  true,  their  real,  proportions."     Criticize. 

Economic  Goods  Have  Definitely  Mensurable  Importance. — 
The  preceding  paragraphs  have  narrowed  down  the  field  of  eco- 
nomic study  to  those  goods  which  possess  effective  importance 
and  which,  therefore,  are  conduct-determining.  But  we  must  carry 
further  this  process  of  delimitation.  Not  all  goods  which  have 
effective  importance  can  properly  be  designated  economic  goods, 
though  this  is  one  of  the  most  essential  characteristics  of  economic 
goods.  Thus  such  goods  as  the  affection  of  our  friends  and  the 
respect  of  our  neighbors  are  by  universal  consent  excluded  from  this 
class.  What,  then,  is  the  characteristic  the  absence  of  which  shuts 
these  out, — the  presence  of  which  makes  a  particular  good  truly 
economic?  This  question  is  not  an  easy  one  to  answer  definitively; 
and  probably  would  be  answered  differently  by  authorities  of  equal 
standing.  I  am  disposed  to  set  up,  as  this  final  distinctive  character- 
istic of  economic  goods,  the  possession  by  such  goods  of  a  special  sort 
of  effective  importance,  namely  an  effective  importance  which  submits 
to  more  definite  measurement  than  the  importance  of  non-economic 
goods  of  this  same  general  class.  Stated  still  more  specifically,  under 
the  present  order,  anyhow,  strictly  economic  goods  consist  of  those 
conduct-determining  goods  the  importances  of  which  can  properly  be 
measured  and  usually  are  measured  in  terms  of  money. 

Economic  Value. — In  the  above  discussion,  I  have  purposely 
chosen  to  use  the  word  importance  in  bringing  out  the  distinctive 
features  of  conduct-determining  goods,  and,  particularly,  that  class 
of  such  goods  which  we  call  economic.  But,  usually,  we  shall  employ 


6  PRINCIPLES  OF  ECONOMICS  [I 

for  this  purpose  another  term,  namely,  value.  Exactly  what  signifi- 
cance ought  to  be  attached  to  this  term  in  economic  discussions  is  not 
easily  settled.  In  general,  I  am  disposed  to  believe  that  the  economist 
ought  to  have  in  the  background  of  his  mind  the  ordinary  conception 
of  value  as  significance  to  the  well-being  of  man.  Such  a  concept 
seems  to  me  desirable  as  furnishing  a  link  between  the  idea  of  im- 
portance and  the  idea  of  "conduct-determining."  That  is,  because 
things  have  importance  for  us,  they  come  to  have  value,  and,  because 
they  have  value,  we  regulate  our  conduct  with  reference  to  them. 
Perhaps  the  word  "worth"  helps  to  bring  out  this  point.  Conduct- 
determining  goods  are  goods  which  are  worth  troubling  about.  In 
this  broad  sense  of  the  word,  value,  all  conduct-determining  goods 
possess  value.  When,  in  addition,  the  particular  goods  in  question 
belong  to  that  division  of  conduct-determining  goods  which  we  call 
economic,  their  value,  like  the  importance  from  which  that  value  is 
derived,  is  one  which  is  capable  of  more  definite  measurement  than 
is  true  of  the  other  type, — is  capable,  that  is,  of  pecuniary  measure- 
ment. By  economic  value,  then,  we  shall  understand  a  worth  or 
value  thus  capable  of  pecuniary  measurement.  Or,  in  short,  economic 
value  will  be  pecuniary  value. 

Economic  Goods  Have  Pecuniary  Value. — It  follows  from 
what  has  just  been  said  that,  in  defining  economic  goods,  we  may 
substitute  for  the  phrase  employed  before,  that  is,  importance  capa- 
ble of  pecuniary  measurement,  the  simpler  phrase,  pecuniary  value. 
In  other  words,  economic  goods  consist  of  that  large  class  of  con- 
duct-determining goods  which  possess  pecuniary  value.  But,  now,  in 
emphasizing  as  the  final  distinguishing  characteristic  of  economic 
goods,  pecuniary  value,  we  must  not  forget  that  the  word  "value," 
as  here  used,  means  something  deeper  than  exchange  value,  means 
worth  or  significance  for  man.  This  way  of  conceiving  economic 
goods  and  value  we  shall  frequently,  though  not  always,  have  in 
mind  when  using  these  terms.4  We  should  remember,  however, 


*  Let  me  say  once  for  all  that  the  term  "value,"  as  well  as  some  others, 
will  be  used  in  a  variety  of  senses.  The  policy,  quite  characteristic  of 
logical  minds,  of  trying  to  employ  every  term  in  just  one  sense,  is  almost 
always  impracticable  and  productive  of  narrowness  in  one's  thinking.  The 


I]  INTRODUCTORY  7 

that  if  our  particular  problem  is  to  decide  whether  or  not  a  given 
good  should  be  accounted  an  economic  good,  under  the  present  order 
the  simplest  test,  and  usually  a  perfectly  adequate  one,  is  the  presence 
or  absence  of  exchange  value  or  price. 

Wealth. — Up  to  this  point,  in  speaking  of  the  goods  with 
which  the  Economist  is  concerned,  we  have  always  referred  to  them 
as  economic  goods.  I  hardly  need  say  that  such  goods  are  very 
commonly  brought  under  the  designation  "wealth."  This  is  a  generic 
term  applied  to  all  goods  which  under  the  present  order  have  ex- 
change value  or  price,  and  only  to  such.  This  practice  makes  it 
comparatively  easy  to  decide  whether  or  not  a  given  object  should 
be  accounted  wealth.  It  also  helps  us  to  work  out  for  ourselves  the 
other  characteristics  which  goods  that  are  accounted  wealth  must 
possess.  For  we  need  have  no  great  difficulty  discovering  what 
characteristics  must  be  present  in  goods  for  which  people  are  going 
to  be  willing  to  give  money. 

ILLUSTRATIVE  PROBLEMS 

1.  "In  order  to  be  an  economic  good — wealth — a  thing  must  have 
utility, — must  be  capable  of  satisfying  some  want."     Argue  for  the  truth 
of  this  statement. 

2.  Show  that  in  order  to  be  wealth  a  thing  must  be  appropriable  and 
transferable. 

3.  Is  the  water  flowing  from  a  spring  by  the  roadside  wealth? 

4.  Is  an  amiable  disposition  wealth?     A  hundred  tons  of  gold  known 
to  be  lying  on  the  surface  of  the  moon?     A  vein  of  coal  existing,  but 
not  known  to  be  existing,  under  a  Michigan  farm? 

5.  It  would  cost  a  good  deal  of  labor  to  cover  the  walls  of  the  houses 
on  Washtenaw  Avenue  with  posters  of  a  circus  given  two  weeks  ago. 
Would  the  result  be  wealth?     What  is  the  point  to  be  made? 

6.  "A  thing  may  have  value  even  though  it  is  not  useful:  e.  g.,  an  old 
stone  prized  by  a  collector."    Point  out  the  error. 


real  thing  has  many  sides  and  there  are  not  words  enough  to  express  every 
different  aspect  of  it  by  a  different  term. 


8  PRINCIPLES  OF  ECONOMICS  [I 

7.  When  we  call  a  man  wealthy  we  mean  that  he  possesses  a  rela- 
tively large  amount  of  this  world's  goods.  Should  we  understand  this  to 
mean  that  the  possessions  of  the  poor  man  are  not  wealth  ? 

Importance  of  Economic  Study. — The  preceding  paragraphs 
have  cleared  up  the  concept  of  economic  goods  and  their  distinguish- 
ing mark,  economic  value.  That  these  goods  and  the  phenomena  con- 
nected with  them  deserve  serious  study  of  some  sort  no  one  would 
doubt.  If  scientific  curiosity  did  not  suffice,  the  fact  that  these  goods 
are  conduct-determining,  that  we  must  act  suitably  or  go  without 
them,  would  surely  settle  the  matter.  Since  we  cannot  have  them 
unless  we  act  in  certain  ways  with  reference  to  them,  it  surely 
behooves  us  to  learn  something  about  them  and  the  conditions  neces- 
sary to  fulfil  if  we  are  to  have  them,  in  order  that  we  may  adjust 
our  conduct  accordingly,  for,  behind  all  correct,  suitable  action,  there 
is  surely  an  art,  a  body  of  rules  which  tell  us  the  course  which  we 
need  to  pursue;  and  behind  such  an  art  there  must  be  a  body  of 
scientific  knowledge  on  which  said  rules  are  based.  Economic 
conduct  is  no  exception  to  this  rule — men  need  a  body  of  rules  to 
guide  their  economic  conduct ;  and  that  body  of  rules  must  rest  on 
a  body  of  scientific  knowledge  with  respect  to  economic  phenomena. 
We,  therefore,  have  highly  practical  and  powerful  motives  for 
developing  and  studying  a  science  of  economics. 

But  just  here  is  needed  a  word  of  caution.  The  scientific  basis 
for  any  art,  the  body  of  knowledge  lying  behind  any  art,  in  most 
cases  consists  of  materials  derived  from  a  number  of  different 
sciences.  Thus,  the  art  of  making  an  automobile  depends  on  the 
sciences  of  metallurgy,  chemistry,  physics,  etc.  To  this  rule, 
again,  the  art  of  economics  furnishes  no  exception.  This  very  making 
of  an  automobile  just  cited  is  in  a  sense  a  part  of  economic  art,  since 
an  automobile  is  an  economic  good ;  and,  hence,  the  art  of  economics, 
in  the  broadest  sense,  builds  on  the  sciences  of  metallurgy,  chemistry, 
physics,  etc.  Similar  statements  would  apply  to  many  other 
economic  activities.  In  fact,  with  respect  to  most  parts  of  that  side 
of  economic  art  which  has  to  do  with  the  producing  of  economic 
goods,  that  art  builds  on  non-economic  sciences.  Thus,  manufac- 
turing in  general  builds  on  the  sciences  just  mentioned  in  connection 


I]  INTRODUCTORY  9 

with  automobile  production;  farming  builds  on  botany,  zoology, 
chemistry,  etc. ;  mining,  on  geology,  mineralogy,  mechanical  engineer- 
ing, etc.  In  other  words,  economics  as  a  science  does  not  claim  to 
include  the  whole  body  of  knowledge  needed  for  the  conduct  of 
economic  art. 

Scope  of  Economics. — But  here,  again,  we  must  not  go  too 
far.  It  is  true  that  the  art  of  economics  builds  on  many  non-economic 
sciences.  Nevertheless,  when  all  these  other  sciences  have  made  their 
contribution,  there  are  kinds  of  knowledge  not  yet  provided  which 
are  found  to  be  needed,  and  supplying  these  gives  rise  to  our  special 
science,  commonly  called  economics,  or  until  quite  recently,  political 
economy.  As  to  just  what  should  be  recognized  as  the  proper 
boundaries  of  economic  science,  authorities  are  not  yet  agreed.  Still, 
when  it  comes  to  determining  the  principal  topics  to  be  treated,  there 
is  no  great  difference  of  practice  among  the  best  writers. 

First,  all  agree  in  giving  a  very  large  amount  of  attention  to  the 
processes  or  principles  under  which  value  or  price  are  determined, 
some  even  going  so  far  as  to  include  no  other  topic  save  as  it  has  a 
pretty  close  relation  to  the  determination  of  prices.  Another  subject 
receiving  much  attention  is  distribution,  the  processes  and  system 
under  which  the  sharing  of  the  wealth  and  income  of  a  community 
among  its  members  is  effected.  In  the  present  economic  order,  this 
is  little  more  than  a  special  division  of  the  theory  of  price,  for  the 
reason  that  the  determination  of  the  incomes  of  the  individuals  is 
largely  a  matter  of  the  prices  received  by  individuals  for  the  services 
they  sell  to  other  persons.  As  respects  production,  bringing  into 
existence  economic  goods,  a  matter  which,  at  first  sight,  might  seem 
to  be  the  most  important  thing  in  economic  science,  a  large  part  of 
this,  as  already  indicated,  is  relegated  to  other  sciences, — the  physical 
or  technological  side  almost  entirely  so.  Economics,  however,  keeps 
to  itself  certain  of  the  most  general  aspects  even  of  the  technique 
of  production,  notably,  the  general  conditions  of  productive  efficiency. 
Further,  most  of  the  productive  processes  in  which  mental  labor  plays 
a  large  part,  especially  if  these  concern  the  exchange  side  of  the 
business,  are  studied  in  sciences  usually  grouped  under  the  head  of 
economics.  Conspicuous  examples  of  this  are  business  organization, 


10  PRINCIPLES  OF  ECONOMICS  [I 

business  management,  marketing,  and  accounting.  Again,  certain 
lines  of  productive  activity — certain  businesses  in  their  entirety — are 
reserved  for  economic  science.  Examples  are  banking  and  the  dif- 
ferent kinds  of  commercial  business,  especially  wholesale  trade  and 
foreign  trade.  Finally,  the  study  of  one  public  institution  of  the 
utmost  importance  in  economic  matters — money — is  treated  as  being 
in  a  peculiarly  important  sense  the  task  of  economic  science.5 

Artificial  Conditions. — In  the  above  account  of  economic 
goods  and  economic  phenomena,  we  have  not  hesitated  to  speak  as 
if  the  case  of  economics  and  that  of  a  science  such  as  chemistry  or 
physics  were  perfectly  analogous.  We  ought  now  to  remark  on  a 
difference  of  considerable  importance  between  the  phenomena  with 
which  we  have  to  deal  and  the  phenomena  of  the  other  sciences.  The 
latter  belong  to  a  group  of  phenomena  which  are  strictly  natural,  in 
the  sense  that  they  are  not  modified  through  conditions  fixed  by  men. 
Economic  phenomena,  in  contrast,  belong  to  a  group  which  are  in 
no  small  degree  artificial :  they  are  influenced  by  conditions  of  human 
origin.  Of  course  all  phenomena  are  natural  in  the  broadest  sense 
of  the  term.  But,  obviously,  some  are  natural  in  a  fuller  and  deeper 
sense  than  others.  Now,  many  economic  relations  are  among  the 
most  truly  natural  and  inevitable  that  can  be  formed ;  many  economic 
phenomena  would  be  just  like  those  we  are  familiar  with  in  the  same 
connections,  even  if  we  lived  like  Crusoes  or,  at  the  opposite  extreme, 
like  a  communistic  society.  But,  in  contrast  with  these,  not  a  few 
economic  phenomena  would  be  very  different  from  what  they  are 
now,  provided  the  conditions  fixed  by  men  were  altered.  For  ex- 
ample, if  legal  changes  were  introduced  giving  the  state  ownership 
of  all  the  land,  the  amount  of  wealth  enjoyed  by  many  persons  would 
be  quite  different ;  if  all  undertaking  of  production  were  legally  left 
to  the  state,  more  or  less  conspicuous  changes  in  price  would  probably 
take  place;  and,  again,  if  the  laws  permitted  us  to  own  laborers  like 
beasts  of  burden,  this  circumstance  would  surely  modify  many 
economic  phenomena.  It  is  plain  also  that  such  conditions  may  be 
brought  about  not  only  by  formal  legislation  but  by  custom,  conven- 

*This  does  not  apply  to  the  technique  of  its  manufacture. 


I]  INTRODUCTORY  II 

tion,  or  formal  agreements.  Thus,  a  general  boycott  of  manufac- 
turers who  employed  non-union  laborers  would  be  an  artificial  con- 
dition of  sufficient  significance  to  influence  wages  and  employment 
quite  seriously. 

An  Economic  Order. — The  point  just  made,  that  artificial 
conditions  play  a  considerable  part  in  determining  economic  phe- 
nomena, naturally  brings  us  to  a  concept  which  has  already  appeared 
in  this  text  under  the  phrase  "economic  order."  By  this  I  mean 
the  totality  of  artificial  conditions,  whether  originating  in  law  or 
custom,  under  which  economic  phenomena  manifest  themselves. 
Such  a  concept  is  necessary  to  the  study  of  economic  science  because 
the  potency  of  artificial  conditions  to  influence  economic  affairs 
makes  possible  the  existence  of  general  situations  in  economic  mat- 
ters which  differ  so  essentially  that  a  body  of  scientific  principles 
applicable  to  one  of  these  would  be  quite  inadequate  for  another. 
Many  such  economic  orders  are  possible;  but  only  three,  or  some 
combination  of  these,  receive  serious  consideration.  These  three  are 
the  present  order,  socialism,  and  communism.  Quite  naturally,  our 
study  is  largely  limited  to  the  present  order.  Not  infrequently,  how- 
ever, that  study  is  illuminated  by  imagining  how  things  would  work 
under  a  communistic  or  socialistic  order. 

Unity  of  Economic  Science. — The  emphasis  just  laid  on  the 
possible  variations  in  economic  principles  growing  out  of  artificial 
differences — differences  in  the  particular  economic  order  prevailing 
— must  not  be  taken  too  seriously.  A  very  large  part  of  the  science 
of  economics,  a  much  larger  part  than  is  commonly  supposed,  would 
be  the  same  under  any  economic  order.  This  applies  not  only  to  such 
technical  matters  as  the  most  efficient  methods  of  production,  a  thing 
which,  of  course,  cannot  be  changed  by  legislation  or  custom,  but 
also  to  the  most  distinctively  economic  of  all  the  problems  of  our 
subject,  the  theory  of  value  in  its  deeper  aspects.  By  this  I  mean 
the  problem,  what  are  the  true  importances  or  values  of  goods  in- 
herent in  a  given  situation,  values  which  a  wise  socialistic  government 
would  try  to  make  their  guide  in  the  conduct  of  economic  affairs, 
and  which  the  defenders  of  the  present  order  claim  are  in  a  fairly 


12  PRINCIPLES  OF  ECONOMICS  [I 

high  degree  represented  in  the  system  of  prices  automatically  worked 
out  under  that  order?  The  mature  student  of  economic  science  and 
economic  practice  will,  I  think,  be  impressed  by  the  essential  oneness 
of  fundamental  economic  phenomena  under  all  systems  and  in  all 
times  and  places,  much  more  than  by  their  differences. 

Economics  a  True  Science. — Up  to  this  point,  it  has  been 
assumed  as  a  matter  of  course  that  economic  phenomena  will  repay 
serious  study,  that  such  study  will  yield  a  body  of  knowledge  which 
may  properly  be  designated  a  science.  This,  perhaps,  seems  too 
optimistic,  in  view  of  the  fact  that  we  often  hear  people  declare  very 
positively  that  there  is  no  economic  science,  that  there  are  no  economic 
principles,  that  in  economic  matters  we  could  not  make  the  smallest 
prediction  with  any  hope  of  its  being  fulfilled.  Such  statements, 
however,  are  not  to  be  taken  seriously.  Any  person  can,  on  the 
spur  of  the  moment,  make  many  predictions  in  economic  matters, 
and  look  forward  to  their  fulfilment  with  perfect  assurance. 

For  example,  if  there  should  be  a  great  falling  off  in  wheat  pro- 
duction next  year,  the  price  would  certainly  rise.  If,  by  the  intro- 
duction of  new  methods,  the  cost  of  producing  almost  any  manu- 
factured article  were  to  fall  fifty  per  cent, — monopoly  being  shut 
out — the  price  of  such  article  would  also  fall.  If  the  price  of 
aluminum  should  decline  fifty  per  cent  there  would  doubtless  take 
place  a  great  extension  of  its  use  in  the  arts.  If  the  government 
should  begin  to  coin  freely  both  gold  and  silver,  putting  only  sixteen 
times  as  much  silver  into  that  kind  of  coin  as  it  did  of  gold  into 
that  kind,  when  on  the  open  market  an  ounce  of  gold  was  worth,  say, 
forty  ounces  of  silver,  the  silver  would  surely  get  the  place  of 
standard  money  while  gold  would  go  to  a  premium  and  rapidly  dis- 
appear from  circulation.  And  so  one  might  go  on.  In  short, 
economic  phenomena,  like  any  other  phenomena,  are  governed  by 
natural  laws.  If  the  group  of  phenomena  in  question  are  of  such  a 
kind  that  several  almost  equal  forces  are  interacting,  it  may  be  im- 
possible to  anticipate  the  result,  just  as  in  complicated  natural  or 
physical  sciences  like  physiology  or  meteorology.  But  in  other  cases, 
when  only  one  or  two  of  the  forces  in  operation  are  of  much  signifi- 
cance, it  will  be  comparatively  easy  to  ascertain  the  probable  outcome. 


I]  INTRODUCTORY  13 

Economics  Abstract  and  Hypothetical. — As  respects  its  gen- 
eral method  of  procedure,  economics  does  not  differ  essentially  from 
other  sciences.  Like  all  thinking,  studying,  knowing,  it  has  to  be 
abstract;  that  is,  it  has  to  withdraw  its  attention  from  many  of  the 
causes  and  conditions  affecting  the  phenomena  studied,  and  confine 
that  attention  to  a  few  of  these.  Further,  economics  is  hypo- 
thetical as  well  as  abstract.  By  this  I  mean  that  economics  assumes 
a  uniformity  in  the  few  causes  and  conditions  which  it  elects  to  study, 
that  in  reality  does  not  exist.  Thus  it  not  only  confines  its  atten- 
tion largely  to  the  working  of  intelligent  selfishness  in  economic 
affairs,  ignoring  the  influence  of  religion,  ethics,  sympathy,  and  so 
on,  but  it  also  thinks  of  that  intelligent  selfishness  as  having  a  quite 
unreal  uniformity  in  respect  to  both  the  stimuli  to  which  it  responds 
and  the  energy  which  it  displays  in  making  this  response. 

Economic  Abstraction  Sound. — Because  of  the  characteristics 
just  brought  out,  there  is  always  danger  that  the  results  obtained  from 
our  study  will  have  but  little  application  to  actual  affairs.  Such 
danger  is  present  in  all  science,  just  because  science  is  necessarily 
abstract.  But  the  student  of  every  subject,  in  making  his  abstrac- 
tions, endeavors,  of  course,  to  choose  for  study  those  causes  and  condi- 
tions which  are  most  fundamental  and  most  powerful  among  those 
bearing  on  the  case.  In  so  far  as  he  succeeds  in  this  endeavor,  the 
results  which  he  obtains  disclose  the  fundamental  and  principal  rela- 
tions among  the  phenomena  involved.  Like  the  teacher  of  anatomy, 
the  teacher  of  economics  begins  by  trying  to  supply  the  student 
with  the  main  framework  of  his  subject,  a  framework  which  is  not 
easily  seen  because  of  the  wealth  of  material  which  covers  it  within 
and  without.  Doubtless,  in  spite  of  all  his  care,  the  teacher  of 
any  subject  may  err  in  the  picture  which  he  gets  and  which  he 
gives  to  others.  In  abstracting  particular  phases  of  his  subject  for 
study,  he  may  choose  trifling  things  instead  of  important  ones  and 
receive  and  impart  a  totally  erroneous  impression.  But,  surely,  the 
chances  are  against  that  result.  Certainly,  in  the  case  of  the  econo- 
mist, there  is  a  strong  presumption  that  he  has  succeeded  fairly  well  in 
avoiding  such  dangers,  since,  in  spite  of  much  seemingly  violent 
controversy,  there  is  very  substantial  agreement  among  leading 


14  PRINCIPLES  OF  ECONOMICS  [I 

economic  writers  in  respect  to  all  of  the  most  fundamental  and  most 
important  doctrines.  Textbooks  prepared  for  the  general  course  in 
economics,  by  adherents  of  different  so-called  schools  of  economic 
thought,  show  a  very  high  degree  of  similarity. 

Apply  Principles  with  Caution. — We  have  just  defended  the 
actual  abstractions  made  use  of  by  economic  science  as  being  sub- 
stantially sound,  not  confining  attention  to  trifles  and  ignoring  the 
more  important  causes  and  conditions  at  work.  We  must  not,  how- 
ever, permit  ourselves  to  forget  that,  after  all,  economic  science  is 
abstract.  It  does  not  attempt  to  cover  the  non-economic  forces  at 
work  in  any  given  case,  nor  even  all  the  economic  forces.  Accord- 
ingly, it  is  of  great  moment  that  we  should  remember  that  we  are  not 
justified  in  making  a  direct  and  immediate  application  of  the  knowl- 
edge derived  from  a  course  like  this  to  the  settlement  of  practical 
problems,  such  as  a  protective  tariff,  governmental  control  of  rail- 
roads, labor  legislation,  etc.  Such  procedure  is  not  justified  in  any 
science ;  since,  whatever  the  science  one  is  studying,  some  time  must 
be  spent  mastering  those  most  general  principles  the  actual  working 
of  which,  though  fundamental,  is,  after  all,  much  modified  by  the 
operation  of  more  superficial  forces.  In  the  case  of  economic  phe- 
nomena, the  too  hasty  application  of  fundamental  principles  to  specific 
problems  is  even  less  justified  than  elsewhere,  because  of  the  great 
number  of  economic  and  non-economic  forces,  which  are  simulta- 
neously acting  at  any  given  moment  and  which  make  the  accurate  dis- 
entangling of  causes  almost  impossible.  It  is,  therefore,  quite  im- 
portant that  the  student  should  exercise  much  self-control  at  this 
point.  In  particular,  he  is  urged  to  suspend  final  judgment  on  almost 
all  great  practical  problems,  such  as  free  trade,  socialism,  trades 
unionism,  etc.,  till  he  takes  courses  subsequent  to  Course  I. 

In  making  use  of  the  present  text  the  advice  just  given  is 
especially  needed  because,  in  the  process  of  trying  to  secure  a 
thorough  comprehension  of  principles,  it  seems  necessary  to  make 
many  applications  of  those  principles  to  actual  problems.  If,  how- 
ever, the  student  will  remember  that  in  these  applications  we  are 
concerned  only  with  the  economic  phase  of  the  problem,  while  in 
actual  life  the  problem  has  many  other  phases,  he  will  realize  that 


I]  INTRODUCTORY  15 

at  present  he  should  attempt  to  reach  a  final  opinion,  not  on  the  whole 
matter,  but  only  on  its  economic  phase. 

As  already  implied  in  the  foregoing,  the  course  upon  which  we 
are  just  now  entering  is  primarily  intended  as  a  foundation  for  later 
study.  It  is,  therefore,  devoted  to  a  severe  discipline  upon  funda- 
mental principles  and  their  applications.  In  general,  our  method  of 
procedure  is  to  introduce  the  concrete  phenomena  needing  explana- 
tion ;  then  to  set  forth  in  formal  fashion  the  principle  which  embodies 
the  explanation ;  to  follow  this  with  adequate  illustration  and  argu- 
ment ;  then  to  finish  with  illustrative  problems  the  solving  of  which 
will  insure  that  the  student  really  masters  the  principle  involved. 
We  advise  that,  in  preparing  the  lesson,  the  student  begin  by  reading 
the  text  carefully,  though  not  attempting  to  master  it ;  that  he  then 
undertake  to  solve  the  illustrative  problems,  recurring  to  the  state- 
ment and  discussion  of  principles  as  he  feels  the  need  therefor ;  and 
that,  finally,  he  go  over  the  entire  discussion  once  more  in  order  the 
better  to  comprehend  it  as  a  whole.  From  the  problems  he  can  obtain 
the  best  results  by  writing  out  the  solution.  In  doing  this,  he  should 
not  rest  satisfied  with  categorical  answers  even  when  these  seem  suf- 
ficient, but  rather  take  pains  to  explain — give  reasons  for — the  con- 
clusion reached.  It  is  essential  above  all  that  he  should  cultivate 
clearness  and  precision  of  statement  and,  where  argument  is  needed, 
should  be  careful  to  include  every  link  of  the  chain  and  to  put  each 
in  its  proper  place. 


CHAPTER  II 

GENERAL  SURVEY  OF  THE  EXISTING  ECONOMIC 

ORDER 

In  the  introduction  we  developed,  among  other  things,  the  notion 
of  an  economic  order — a  totality  of  conditions  under  which  economic 
phenomena  take  place;  and  we  explained  that  our  study  is  mainly 
concerned  with  the  particular  economic  order  now  existing, — the 
phenomena  displayed  under  it  and  the  natural  laws  governing  those 
phenomena.  Our  first  task,  before  undertaking  a  detailed  study  of 
the  economic  order,  is  to  get  a  general  view  of  it  and  familiarize  our- 
selves with  its  most  conspicuous  features.  To  this  task  we  shall 
devote  ourselves  in  the  present  chapter  and  the  next. 


The  Present  Order  One  of  Individual  Exchange-Cooperation 

The  general  situation  in  which  men  find  themselves  is  this :  First, 
they  exist,  and  by  the  fact  of  their  existence  they  have  wants  which 
imperatively  demand  satisfaction.  Secondly,  the  satisfying  of  these 
wants  depends  on  the  possession  of  certain  economic  goods.  Finally, 
the  getting  of  the  goods  depends  on  some  acts,  efforts,  of  man  him- 
self. Speaking  broadly,  man  must  make  his  own  living.  He  must 
perform  some  part,  large  or  small,  in  the  process  by  which  he  becomes 
possessed  of  the  necessary  goods.  Now,  as  making  possible  the  ac- 
complishment of  this  task,  he  finds  at  his  disposal  two  sets  of  condi- 
tions, or  instrumentalities:  (i)  his  own  outfit  of  capacities,  mental 
and  physical,  and  (2)  an  outside  world  of  material  objects  and  con- 
ditions which  in  one  way  or  another  can  be  drawn  upon  and  utilized. 
Starting  with  this  general  situation,  there  are  several  possible  ways  in 
which  his  task  of  making  a  living  might  be  accomplished. 

16 


II]  GENERAL  SURVEY  17 

Different  Possible  Economic  Orders. — First,  an  economic 
order  can  at  least  be  conceived  in  which  the  goods  needed  by  the 
individual  are  made  available  by  his  own  efforts,  unaided  by  his 
fellow  men.  Crusoe  is  represented  as  contriving  to  satisfy  his  wants, 
in  so  far  as  they  were  satisfied  at  all,  almost  wholly  by  the  labor  of 
his  own  hands;  and  it  is  probable  that  many  hunters  and  explorers 
for  a  time  approximate  his  condition.  A  pioneer  or  isolated  settler 
also  to  a  great  extent  produces  the  very  things  which  he  consumes 
and  consumes  nothing  but  what  he  himself  produces — bakes  his  own 
bread  and  eats  it,  grinds  his  own  flour  and  bakes  it  into  bread,  raises 
his  own  wheat  and  grinds  it  into  flour.  Such  an  order,  where  each 
man  provides  directly  and  entirely  for  the  satisfaction  of  his  own 
wants,  may  be  called  an  autonomous  economic  order. 

At  the  opposite  pole,  we  have  an  economic  order  in  which  all 
the  people  of  a  community  cooperate  in  a  completely  organised  way 
in  the  getting  of  economic  goods.  The  community  owns  all  the  re- 
sources, undertakes  all  production,  and  sees  that  each  person  gets 
what  he  needs  or,  anyhow,  what  the  community  can  afford  to  let  him 
have.  Such  an  economic  order  is  commonly  designated  Communism. 

A  somewhat  less  completely  organized  system  of  cooperation 
would  leave  to  individuals  greater  freedom  of  action,  in  that,  while 
the  community  owned  all  goods  used  in  production  and  undertook 
all  production,  the  individual  would  be  hired  by  the  community  and 
paid  wages,  and  would  be  permitted  to  buy  and  own  such  consump- 
tion goods  as  he  chose,  instead  of  being  taken  care  of  like  the  mem- 
bers of  a  family.  A  system  of  this  general  character  is  usually 
called  by  economists  Socialism  or  Collectivism. 

The  two  possible  economic  systems  last  described  are  both  co- 
operative, as  must  be  all  but  the  one  first  described — the  autonomous 
one.  But  neither  of  these,  as  the  student  is  doubtless  aware,  is  any- 
where fully  established,  though  experiments  in  this  direction  are 
being  made  on  a  gigantic  scale  in  various  countries.  In  contrast,  the 
actual  system  of  most  civilized  countries  is  one  in  which  the  co- 
operation involved,  instead  of  being  organized,  conscious,  is  rather 
spontaneous,  automatic — effected  and  regulated  through  free  ex- 
change between  individuals  or  non-political  groups.  This  system  we 
shall  call  one  of  Individual  Exchange-Cooperation. 


jg  PRINCIPLES  OF  ECONOMICS  [II 

The  Present  Order  Cooperative. — But  we  need  to  make  some 
more  specific  comments  on  this  order.  First,  we  must  emphasize  the 
general  point  that  the  system  is  cooperative.  This  is  necessary  for 
the  reason  that  not  a  few  people  are  accustomed  to  think  of  this  order 
as  emphatically  not  cooperative.  In  fact  they  very  often  urge  the 
adoption  in  its  place  of  some  system  which  is  cooperative.  Now,  of 
course,  it  is  perfectly  legitimate  to  understand  cooperation  in  senses 
which  would  not  be  suitable  in  describing  the  present  order.  For 
example,  there  is  a  special  system  of  acting  together  among  the  con- 
sumers of  certain  types  of  commodities  whereby  they  themselves 
undertake  the  business  through  which  these  commodities  are  obtained. 
Thus  we  sometimes  have  cooperative  bookstores  in  college  towns. 
In  England  there  are  many  cooperative  shops  for  groceries,  meat, 
and  other  household  supplies.  Again,  we  have  a  few  cases  of 
producers'  cooperation,  wherein  the  laborers  in  a  business  under- 
take to  run  that  business.  Other  uses  of  the  term  could  doubtless  be 
found.1  So,  of  course,  the  communism  or  socialism  described  above 
would  be  cooperative  in  a  sense  that  the  present  order  is  not.  Never- 
theless, it  is  unquestionably  true  and  of  the  greatest  importance  that 
the  present  order  is  cooperative.  For  it  contains  the  essential 
feature  of  cooperation.  The  members  of  society  act  together  in 
supplying  their  wants.  Each  person  produces  almost  entirely  for 
other  people's  consumption;  each  person  consumes  almost  entirely 
what  other  people  have  produced. 

Spontaneous  Exchange-Cooperation. — We  have  seen  that  the 
present  economic  order  is  essentially  cooperative.  A  second  special 
characteristic  of  that  order  is  found  in  the  peculiar  way  in  which  our 
cooperation  is  brought  about.  Ordinarily,  in  speaking  of  coopera- 
tion, we  think  of  it  as  being  conscious,  organised  cooperation,  brought 
about  either  by  agreement  or  authority.  Thus,  people  cooperate  in 
getting  up  a  church  supper  or  picnic,  through  agreement.  On  the 

1  It  perhaps  ought  to  be  added  that  people  every  now  and  then  use 
the  word  cooperation  for  a  species  of  acting  together,  which  most  economists 
condemn,  that  is,  the  acting  together  of  persons  engaged  in  the  same 
business.  "We  are  hurting  ourselves  by  this  heartless  competition,"  say  the 
grocers ;  "let  us  cooperate, — treat  each  other  as  brothers, — live  and  let 
live."  Very  nice  for  the  grocers,  but  hard  on  the  rest  of  us. 


II]  GENERAL  SURVEY  ig 

other  hand,  in  the  family  we  have  cooperation  brought  about  by  the 
authority  of  one  or  both  the  parents,  and  in  communistic  societies — 
Shakers,  Oneida,  Amana, — many  of  which  have  existed  in  the  United 
States,  we  have  cooperation  effected  by  the  authority  of  the  com- 
munity. In  contrast  with  such  conscious,  organized  forms,  the  co- 
operation of  the  present  order  results  from  the  spontaneous  action  of 
individuals  in  producing  goods  wanted  by  other  persons,  and  ex- 
changing those  goods  for  goods  which  the  others  have  produced. 
That  is,  the  element  which  effects  our  cooperation  under  the  present 
order  is  Exchange.  This  second  feature  of  the  order  is  brought  out 
by  denominating  that  order  one  of  Exchange-Cooperation. 

Cooperation  Regulated  through  Exchange. — A  third  charac- 
teristic of  the  present  order,  and  one  which  furnishes  an  additional 
reason  for  denominating  it  an  order  of  Exchange-Cooperation,  is 
found  in  the  way  our  cooperation  is  regulated.  It  is  pretty  clear 
that,  if  we  have  any  cooperation  at  all,  there  must  be  some  way  of 
regulating  that  cooperation.  We  need  more  of  some  things  than  of 
others.  We  need  certain  things  so  much  that  it  will  pay  us  to  have 
them  even  at  the  cost  of  going  without  some  other  things  altogether. 
Unless  there  is  some  guiding,  directing  machinery,  we  shall  be  wasting 
our  resources  producing  the  wrong  things  or  the  right  things  in  the 
wrong  proportions.  Now,  in  some  kinds  of  cooperation  this  regulat- 
ing is  done,  or  would  be  done,  by  authority.  This  is  the  case  within 
the  family.  How  much  time  the  farmer's  boy  shall  put  in  weeding 
the  garden,  how  much  splitting  wood,  and  how  much  picking  up 
stones,  the  farmer  determines  by  authority;  and  such  a  system 
prevails  in  the  main  in  the  communistic  societies  to  which  reference 
has  already  been  made.  Dut,  throughout  most  of  the  present  order, 
our  cooperation  is  regulated  by  the  same  machinery  of  exchange 
which  effects  that  cooperation,  and  in  the  same  spontaneous  way. 
If  too  little  of  anything  is  produced,  price  rises  or  the  market  ex- 
pands, profits  increase,  and  so  producers  of  their  own  motion  increase 
output ;  if,  on  the  other  hand,  too  much  of  anything  is  produced,  price 
falls  or  the  market  contracts,  profits  diminish,  and  so  producers  of 
their  own  motion  diminish  output.  Again,  if  the  output  of  some 
commodity  during  a  particular  year  is  exceptionally  small,  so  that 


20  PRINCIPLES  OF  ECONOMICS  [II 

consumption  all  along  the  line  needs  to  be  curtailed,  this  is  usually 
accomplished,  not  by  the  interposition  of  the  public  authorities,  but 
by  an  automatic  rising  of  price  which  induces  almost  every  one  to 
cut  down  consumption  of  his  own  motion.  So,  in  these  and  various 
other  ways,  exchange  regulates  our  cooperation. 

Individual  Initiative. — We  have  seen  that  the  present 
economic  order  is  one  wherein  men  cooperate  and  wherein  their  co- 
operation is  effected  and  regulated  through  exchange.  The  fourth 
and  last  dominant  feature  of  the  order  is  individual  initiative.  It  is 
quite  possible  to  conceive  a  system  of  cooperation  which,  in  part  at 
least,  is  effected  and  regulated  through  exchange,  but  in  which 
initiative  is  left  to  society  as  a  whole,  government.  Thus,  under 
socialism  as  it  is  commonly  advocated,  the  state  would  be  the  sole 
farmer,  miner,  manufacturer,  or  merchant, — the  state  alone  would 
undertake  to  produce  things,  putting  all  individuals  into  the  position 
of  employees.  But  it  would  still  enter  into  exchange  relations  with 
these  individuals,  buying  their  services  in  the  open  market  and  selling 
them  its  products.  Further,  it  very  probably  would  depend  on  freely 
determined  prices  to  guide  or  regulate  production  in  the  same  way 
that  they  do  at  present.  But  while  such  a  system  would,  like  the 
present,  be  a  system  of  exchange  cooperation,  it  would  differ  radically 
in  leaving  all  initiative  to  the  state;  whereas,  in  the  present  order, 
initiative  is  mostly,  though  not  entirely,  the  business  of  the  individual, 
— persons  who  have  the  means  and  think  they  see  a  chance  to  obtain 
profits  set  about  producing  wheat  or  iron  or  chairs  or  what  not. 
Accordingly,  to  give  something  like  a  complete  characterization  of 
the  present  order  in  its  most  general  features,  we  have  to  say  that 
it  is  a  system  of  Individual  Exchange-Cooperation. 

One  point  in  the  foregoing  description  should  perhaps  receive 
special  emphasis  before  we  pass  on.  Our  affirmation  that  the  existing 
order  is  regulated  through  exchange  may  awaken  surprise  or  doubt 
in  some  who  were  unaware  that  the  order  is  regulated  at  all.  Many 
people  have  never  recognized  in. exchange  the  possibilities  of  a 
regulating  factor ;  they  have  assumed  that  the  only  such  factor  that 
could  exist  is  some  kind  of  conscious  interference;  and,  knowing 


II]  GENERAL  SURVEY  21 

that  there  is  little  such  interference  in  our  order,  they  pass  to  the 
natural  conclusion  that  our  order  is  almost,  if  not  entirely,  unregu- 
lated. Indeed,  there  is  nothing  more  common,  even  among  educated 
people,  than  the  notion  that,  save  for  a  slight  authoritative  inter- 
ference here  and  there,  the  present  order  is  quite  without  regulation, 
and  therefore  exists  in  a  state  of  chaos  or  anarchy,  governed  only 
by  chance.  Now,  this  is  surely  quite  contrary  to  the  facts.  Economic 
actions  are  regulated  actions.  They  are  organized  and  correlated  so 
as  to  accomplish  uniform  and  regular  results.  The  fact  that  the 
regulation  is  spontaneous,  and  hence  to  some  extent  concealed,  does 
not  make  it  any  the  less  real.  It  would  be  impossible,  or  at  any 
rate  inexpedient,  to  attempt  in  this  place  a  fuller  description  of 
the  process  by  which  the  regulating  actually  takes  place.  But  the 
more  specific  and  detailed  argument  for  it  will  be  supplied  as  our 
knowledge  of  the  economic  order  expands  in  the  progress  of  this 
course. 

In  saying  that  the  economic  order  is  regulated,  we  do  not  intend 
of  course  to  intimate  that  it  is  regulated  in  a  manner  altogether  just 
and  expedient.  The  time  has  not  come  to  go  into  this  topic  at  all 
fully ;  but  even  at  this  stage  so  much  should  be  made  clear.  No  one 
claims  that  the  present  system  works  perfectly,  that  there  are  no 
evils  which  society  ought  to  try  to  eliminate.  There  surely  are  not 
a  few  places  where  spontaneous  regulation  fails  to  attain  good  re- 
sults, and  it  surely  is  possible  that  at  these  points  some  other  form 
of  regulation  would  do  better.  But  even  so,  we  must  still  insist  that 
the  present  order  is  not  chaotic,  that  it  is  a  regulated  and  a  ration- 
ally regulated  order,  though  one  in  which  the  process  of  regulation 
is  automatic. 

ILLUSTRATIVE  PROBLEMS 

1.  Give  some  examples  of  autonomous  production   from  everyday 
experience. 

2.  "Robinson  Crusoe,  on  his  far-away  island,  had  neither  trade  nor 
commerce.     Except  for  the  supplies  that  he  recovered  from  the  wreck 
of  the  ship,  he  obtained  his  food  from  the  plants  that  he  cultivated  and 
from  the  wild  animals  that  he  killed.     His  clothing  was  made  from  the 
skins  of  goats;  his  table  and  his  chairs  were  the  work  of  his  own  hands. 


22  PRINCIPLES  OF  ECONOMICS  [II 

Even  his  shelter  was  constructed  of  the  stone  and  wood  that  he  found 
on  the  island.  If  he  had  more  of  one  product  than  he  needed  he  could 
not  exchange  it  for  other  necessary  articles.  If  provisions,  utensils, 
clothing,  tools,  or  metals  were  lacking,  he  could  not  buy  them.  He  was 
by  turns  hunter,  fisher,  tanner,  farmer,  miller,  baker,  blacksmith,  and 
carpenter." 

The  above  is  the  opening  paragraph  of  a  book  on  Commercial 
Geography.  It  seems  intended  to  suggest  the  significance  and  importance 
of  commerce  by  setting  forth  the  disadvantages  of  isolation  such  as 
Crusoe's.  What  was  the  real  nature  of  the  drawback  in  his  situation 
which  it  brings  out? 

3.  "In  the  main,  industry  is  organized  in  a  spontaneous  way.    Men 
choose  such  occupations  as  they  like,  and  when  there  are  too  many  of 
them  in  one  group  and  too  few  in  another,  the  automatic  working  of 
economic  forces  moves  them  from  the  former  to  the  latter."     Explain 
and  illustrate  the  last  clause  of  that  sentence. 

4.  "The  great  advantage  of  foreign  trade  is  in  furnishing  a  market 
for  our  surplus  products  which  would  otherwise  go  to  waste."     This 
surely  is  only  a  minor  advantage  of  foreign  trade.    Why?     Give  some- 
thing better. 

5.  If  the  potato  crop  of  a  communistic  society  which  had  no  com- 
merce with  other  communities  were  to  fall  off  one-half,  how  would  they 
regulate  the  consumption  of  potatoes  for  the  following  year?    How  is  it 
done  under  the  present  order? 

6.  "It  will  never  pay  us  to  import  anything  which  we  ourselves  can 
produce."     Show  that  this  proposition  is  erroneous. 

7.  "If  the  results  which  follow  from  allowing  prices  to  be  determined 
under  the  free  working  of  economic  forces  do  not  satisfy  us,  we  should 
try  to  improve  those  results  by  the  adoption  of  subsequent  measures, — 
we  should  if  possible  avoid  all  direct  interference  with  the  free  determi- 
nation of  prices. 

Defend  that  statement. 

8.  Suppose  that  a  wave  of  sentiment  in  favor  of  higher  wages  for 
workmen  in  one  particular  industry,  say  railway  transportation,  passes 
over  the  country,  and  as  a  result  these  wages  are  actually  pushed  much 
above  what  they  would  tend  to  be  under  the  natural  working  of  things. 
Argue  that  such  a  policy  would  be  inexpedient. 


II]  GENERAL  SURVEY  23 

II 
Forms  and  Forces  of  Individual  Exchange  Cooperation 

Specialization. — To  a  very  limited  extent,  our  cooperation  in 
the  present  order  is  homogeneous;  we  combine  to  do  something  which 
requires  that  all  shall  act  in  the  same  general  way,  as  when  a  number 
of  men  carry  a  steel  rail.  But,  generally  speaking,  our  cooperation 
is  heterogeneous.  Each  person  does  a  different  thing  from  the  rest, 
though  the  actions  of  all  may  be  combined  and  ordered  to  a  common 
end.  But  this  differentiating  the  tasks  involved  in  the  cooperative 
process  and  assigning  them  to  different  persons  is  not  something 
merely  occasional  or  extemporized.  The  particular  task  undertaken 
by  each  is  habitually  undertaken  by  him;  he  regularly  performs  this 
task  and  no  other.  Now,  such  a  practice  is  known  as  division  of 
labor  or  specialisation.  And  this  specialization,  as  one  of  the  most 
important  features  of  our  cooperation,  should  be  examined  somewhat 
more  specifically. 

One  form  of  specialization  is  that  wherein  each  producer  is  en- 
tirely responsible  for  a  complete  product.  Thus  the  farmer  plants 
his  potatoes,  hoes  them  while  they  are  growing,  and  finally  digs  and 
sorts  them  into  bags,  ready  for  the  consumption  of  his  several  neigh- 
bors ;  while  one  of  those  neighbors,  the  carpenter,  might  draw  the 
plans  for  a  house,  procure  the  lumber  therefor,  and  finish  the  structure 
complete,  ready  for  the  farmer's  occupancy. 

But,  as  every  one  knows,  specialization  commonly  goes  much 
further  than  this.  Practically  no  one  in  a  highly  organized  society 
carries  from  beginning  to  end  the  processes  necessary  to  the  produc- 
tion of  a  finished  consumption  good.  The  work  of  the  baker  in 
producing  bread  is  preceded  by  that  of  the  miller  in  producing  flour 
and  that  of  the  miller  in  turn  by  the  work  of  the  farmer  in  producing 
wheat.  So  likewise  the  work  of  the  shoemaker  is  preceded  by  that 
of  the  tanner,  and  the  work  of  the  tanner  by  that  of  the  stock-raiser. 
Each  commodity,  in  short,  comes  to  its  ultimate  consumer  as  a  result 
of  efforts  spent  upon  it  by  a  long  series  of  different  producers.  In 
addition,  the  various  members  in  the  original  series  make  use  of 
the  products  and  services  of  producers  in  various  other  series.  Thus 


24  PRINCIPLES  OF  ECONOMICS  [II 

the  cattle-raiser  avails  himself  of  the  wagons,  harness  and  wire 
fences  produced  by  certain  manufacturers.  The  tanner,  again,  uses 
coal,  bark,  and  cloth,  and  the  shoemaker  uses  thread,  bristles,  needles, 
and  machinery,  each  of  which  has  been  brought  to  perfection  by  as 
many  and  various  independent  series  of  producers. 

Internal  Specialization. — But  in  an  economic  society  so  highly 
developed  as  ours,  cooperation  and  specialization  go  still  further  than 
we  have  yet  indicated.  In  the  case  last  mentioned  we  were  thinking 
of  industrial  units  which,  though  devoted  each  to  producing  only  a 
single  element  in  the  ultimate  product,  were  yet  undivided  units. 
It  was  the  stock  farm  as  a  whole  which  we  conceived  of  as  raising 
cattle  and  the  tannery  as  a  whole  which  we  conceived  of  as  preparing 
hides  for  leather.  But  in  reality  each  such  industrial  unit  is  divided : 
there  is  specialization  within  it.  In  the  tannery  which  as  a  whole 
produces  leather,  some  men  attend  to  the  scraping  of  hides,  some  to 
the  curing  of  the  hides  in  the  various  baths,  some  to  staining,  some 
to  finishing,  some  to  keeping  books,  some  to  writing  letters. 

Specialization  in  All  Factors. — A  point  with  respect  to  spe- 
cialization which  is  much  too  important  to  be  neglected  may  naturally 
be  presented  in  this  connection.  Specialization  is  not  limited,  as 
may  seem  to  have  been  implied  in  the  preceding  discussion,  to  human 
beings.  For  human  beings  necessarily  use  lands,  machinery,  and  tools 
in  their  work ;  and  these  assisting  factors  become  specialized  just  as 
do  the  men  themselves.  Each  tool  and  machine  is  more  and  more 
confined  to  the  performance  of  one  small  job;  one  portion  of  land  is 
devoted  to  celery,  another  to  onions,  another  to  citrous  fruits,  and 
so  on. 

Functional  Specialization. — But  we  have  not  yet  brought  out 
the  full  extent  of  specialization  under  the  present  order.  The  spe- 
cialization thus  far  considered  grows  more  especially  out  of  the 
differences  in  the  physical  or  technical  operations  to  be  performed 
in  getting  a  product  ready  for  consumption.  But  there  is  an  even 
deeper  kind  of  specialization.  In  speaking  of  it  we  shall  be  antic- 
ipating somewhat  the  contents  of  a  later  chapter,  but  the  broad  facts 


II]  GENERAL  SURVEY  25 

can  after  all  be  very  easily  understood.  We  already  had  occasion  in 
the  last  paragraph  to  mention  the  fact  that  when  a  man  engages 
in  productive  operations  he  does  not  work  alone,  but  brings  to  the 
aid  of  his  labor  various  factors  outside  himself,  land  and  materials, 
tools,  machinery,  etc  Now,  with  the  development  of  industrial 
society  under  a  system  of  exchange  cooperation,  it  has  come  about 
that  the  labor  for  productive  operations  is  furnished  by  one  person 
or  class  of  persons,  the  land  by  another,  much  of  the  capital  invested 
in  tools,  machinery,  etc.,  by  another,  and  the  initiative  in,  or  responsi- 
bility for,  production  by  still  a  fourth.  The  people  furnishing  these 
different  necessary  factors  may  therefore  be  said  to  specialize.  Here, 
manifestly,  we  have  a  deeper  sort  of  specialization  than  anything  yet 
considered.  For  lack  of  a  better  term  I  will  designate  it  functional 
specialisation. 

To  summarize  this  discussion :  the  present  economic  system  pre- 
sents itself  to  us  as  one  wherein  we  have  a  vast  complex  of  different 
industries — mining,  stock-raising,  farming,  manufacturing,  transport- 
ing, etc. — each  concerned  in  the  production  of  some  commodity  at 
one  or  another  stage  of  completion ;  that,  within  each  of  these  indus- 
tries, different  functional  groups  of  productive  agents  are  cooperat- 
ing, and  that,  finally,  this  vast  industrial  complex  is  brought  to- 
gether, is  held  together,  and  is  regulated  through  exchange — buying 
and  selling.  The  existing  system  is  thus  seen  to  be  one  of  extraor- 
dinary complexity,  very  confusing  to  the  general  public  and  not  a 
little  so  to  the  trained  thinker.  It  is  often  difficult  to  isolate  the  pre- 
cise function  performed  by  a  given  business,  and  people  who  form 
hasty  conclusions  are  apt  to  deny  the  existence  of  such  a  function,  to 
affirm  that  the  business  in  question  plays  no  legitimate  part,  so  that 
those  who  pursue  it  are  mere  parasites  upon  society.  We  shall  do 
well,  however,  to  assume  at  the  outset  that  every  occupation  not 
catering  to  human  vice  plays  a  real  and  legitimate  role  in  the  total 
conduct  of  economic  affairs,  is  doing  some  one  of  the  numberless 
things  necessary  to  be  done  if  the  wants  of  mankind  are  to  be  satis- 
fied in  the  fullest  possible  measure. 

Competition. — We  have  remarked  on  some  important  phases 
of  the  specialization  which  forms  so  vital  an  element  in  the  present 


26  PRINCIPLES  OF  ECONOMICS  [II 

economic  order.  We  must  now  comment  on  another  very  important 
element  in  this  order,  an  element  which  is  often  thought  of  as  the 
most  characteristic  feature  of  the  system.  That  element  is 
Competition. 

Dangers  Incident  to  Cooperation. — To  begin  with,  let  us  re- 
mind ourselves  once  more  that  the  present  economic  order  is  a  co- 
operative one.  Most  of  the  goods  we  produce  are  destined  to  satisfy 
the  wants  of  other  people;  and  most  of  the  goods  destined  for  the 
gratification  of  our  wants  are  produced  by  other  people.  But,  now, 
very  little  reflection  is  needed  to  convince  any  person  that,  when 
people  cooperate,  whether  in  an  economic  order  like  the  present  one 
or  in  an  order  like  communism  or  socialism,  there  will  always  be  a 
temptation  assailing  each  one  to  give  to  the  joint  output  as  little  as 
possible  and  to  take  from  that  joint  output  as  much  as  possible.  Just 
because  I  am  producing  things  for  people  other  than  myself,  I  might 
easily  be  tempted  to  put  poor  materials  into  my  product,  to  avoid 
working  very  hard  or  very  carefully  on  that  material,  to  try  to  get 
from  my  customers  prices  for  my  product  higher  than  their  real 
value,  and  so  on.  In  fact,  as  we  all  know,  this  is  in  some  measure 
true  of  the  present  system  as  it  really  works. 

Methods  of  Meeting  Those  Dangers. — But  it  is  hardly  neces- 
sary to  say  that  society  has  always  recognized  this  danger  and  the 
need  for  some  plan  or  device  for  meeting  it.  In  a  society  where  volun- 
tary communism  has  been  maintained,  the  influence  of  a  sense  of 
religious  duty  has  usually  been  depended  upon,  though  without  great 
success,  to  accomplish  the  result.  Under  socialism  and  state  com- 
munism, public  authority  would  probably  be  used  to  meet  this  need, 
as  would  seem  to  be  the  case  in  Russia  at  the  present  time.  But, 
under  an  order  of  free  private  initiative,  such  as  ours,  the  force 
commonly  depended  upon  is  free  competition, — that  is,  the  un- 
hindered effort  of  each  producer  to  get  or  keep  patronage  which 
might  go  to  rivals. 

Presumptive  Efficiency  of  Competition.  — The  a  priori  grounds 
on  which  we  might  expect  free  competition  to  guard  us  pretty  well 


II]  GENERAL  SURVEY  27 

against  the  dangers  incident  to  all  economic  cooperation  are  easily  set 
forth.  If,  as  a  producer,  I  had  no  need  to  think  of  anyone  but  my 
customers,  the  temptation  to  gain  at  their  expense  which  has  been 
noted  might  generally  prove  too  strong.  But  there  are  other  people 
whom  I  have  to  consider,  namely,  my  rivals,  other  persons  producing 
in  the  same  line  as  myself.  The  fear  that  such  persons  will  get  my 
customers  to  buy  from  them  instead  of  from  me,  says  to  me  in  very 
emphatic  tones  :  Do  nothing  to  the  disadvantage  of  your  customers ; 
don't  put  in  poor  materials  or  work ;  don't  take  advantage  of  their  ig- 
norance ;  don't  try  to  deceive  them ;  and  so  on.  Put  positively,  that 
fear  of  rivals  says :  Do  everything  possible  to  the  advantage  of  cus- 
tomers ;  be  eager  to  anticipate  their  wants ;  put  in  better  and  better 
materials;  improve  the  quality  of  your  work;  show  yourself  really 
interested  in  doing  the  best  you  can  by  them ;  and  so  on.  Manifestly, 
we  have  here  a  force  which  tends  strongly  to  offset  the  dangerous 
tendencies  naturally  present  in  all  cooperation. 

Enforced  Freedom  of  Competition. — That  free  competition 
must  be  recognized  as  a  vital,  fundamental  necessity  of  the  present 
order  is  surely  evident  from  the  considerations  set  forth  in  the  last 
two  paragraphs.  Conceivably  it  might  be  better  to  do  away  with  our 
present  system  altogether,  to  substitute  therefor  a  system  of  organized 
cooperation  like  socialism,  in  which  case  we  should  have  to  depend 
largely  on  some  other  method  of  avoiding  the  dangers  which  grow 
out  of  cooperation.  But,  so  long  as  we  attempt  to  maintain  the  present 
system  of  spontaneous  cooperation,  we  should  in  every  way  strive  to 
maintain  freedom  of  competition.  And,  in  fact,  this  is  the  almost 
universal  policy  of  governments  at  the  present  time.  The  only  ex- 
ceptions are  those  cases  where  experience  has  shown  that  free  compe- 
tition cannot  be  maintained  or  its  maintenance  will  on  the  whole 
work  more  evil  than  good.  With  these,  government  control  or  gov- 
ernment regulation  is  substituted  for  freedom  of  competition.  But 
these  cases  are  decidedly  the  exception.  The  general  rule  is  enforced 
freedom  of  competition.  Even  when  governments  undertake  direct 
control  or  regulation,  they  usually  set  up  as  the  ideal  of  their  regula- 
tion the  results  which  it  is  conceived  would  follow  were  competition 
perfectly  free. 


28  PRINCIPLES  OF  ECONOMICS  [II 

Competition  Versus  Cooperation  of  Like  Units. — The  im- 
portance of  free  competition  in  the  present  system  makes  it  almost 
necessary  to  comment  on  a  certain  matter-of-course  condemnation  of 
such  competition  which  has  very  wide  vogue.  Certain  types  of  men 
talk  and  write  with  much  eloquence  about  the  wicked  and  unchristian 
character  of  competition,  and  roundly  affirm  that  cooperation  would  be 
so  much  better,  so  much  more  human  and  Christian,  meaning  by  co- 
operation this  time,  cooperation  among  like  units,  like  producers.  If 
such  cooperation  is  being  carried  out  by  very  wealthy  men  in  great 
corporations  like  the  Standard  Oil  Company,  the  enthusiasts  for 
cooperation  talk  in  a  different  vein.  In  fact,  they  are  quite  likely  to 
indulge  in  disagreeable  epithets  such  as  "grinding  monopoly,"  "the 
robber  barons  of  our  day,"  and  so  on.  But  cooperation  which  is 
limited  to  their  own  particular  group  and  so  is  likely  to  serve  their 
selfish  ends,  or  cooperation  which  applies  to  some  class  with  which 
they  have  special  sympathy,  they  defend  in  warmest  language. 
Whether  there  is  any  possible  justification  of  such  an  attitude,  I  will 
not  here  attempt  to  say.  One  thing,  however,  is  certain.  Any  notion 
that  free  competition  is  per  se  wrong,  that  cooperation,  in  the  sense 
here  considered,  is  inherently  the  only  righteous  policy, — any  such 
notion  is  thoroughly  unsound.  In  fact,  the  truth  is  precisely  contrary. 
Only  free  competition  is  right;  cooperation  is,  prima  facie,  wicked. 
Cooperation,  in  the  sense  indicated,  is  only  a  pleasant  name  for  com- 
bining to  take  advantage  of  your  customers,  or  the  dealers  of  whom 
you  are  customers. 

Competition  as  a  Regulative  Instrumentality. — We  have  seen 
the  importance  of  free  competition  as  the  instrumentality  depended 
upon  to  hinder  the  selfishness  of  the  individual  from  interfering 
seriously  with  the  working  of  the  present  order  in  respect  to  fairness 
and  efficiency.  Attention  ought  also  to  be  called  to  the  part  played  by 
competition  as  a  regulative  instrumentality.  Every  person  who  en- 
gages in  production  hopes,  of  course,  to  dispose  of  his  own  goods  and 
obtain  other  goods  in  spite  of  the  presence  of  his  competitors.  But, 
in  order  to  exchange  at  all,  one  must  accept  as  low  prices  and  pay  as 
high  prices  as  his  competitors.  Now  for  the  individual  this  necessity 
may  prove  to  be  extremely  trying.  It  often  costs  one  man  more  to 


II]  GENERAL  SURVEY  29 

turn  out  his  products  than  it  costs  his  competitors,  and  so  if  he  sells 
as  low  as  they,  he  may  get  out  of  the  exchanging  process  less  than  he 
puts  into  it.  And  if  he  continues  long  doing  business  on  any  such 
principle,  he  will  of  course  come  to  ruin. 

Now  the  real  difficulty  with  any  individual  in  this  situation  is 
that  he  has  not  been  able  to  produce  the  particular  commodity  which 
he  brings  to  exchange  as  efficiently  or  as  cheaply  as  his  competitors. 
To  save  himself,  therefore,  he  will  be  forced  to  quit  that  field  of 
production  and  go  out  seeking  among  other  fields  for  one  in  which 
the  advantage  does  not  lie  so  much  with  his  competitors.  Only  those 
with  independent  incomes  can  choose  and  indefinitely  persist  in  an 
occupation  which  does  not  produce  something  they  can  sell  to  ad- 
vantage. In  other  words,  the  result  of  competition,  of  competitive 
exchange,  is  to  force  each  person  into  that  field  of  productive  employ- 
ment for  which  he  is  best  fitted.  Specialization,  as  already  pointed 
out,  is  an  essential  feature  of  our  cooperative  order.  Hence,  competi- 
tion, which  guides  our  specialization,  which  leads  us  inevitably  to 
specialize  in  the  employment  where  we  can  produce  most  efficiently, 
which  makes  our  specialization  more  perfect — is  also  cooperative. 
Its  final  result  is  the  more  effective  satisfying  of  human  wants  as  a 
whole. 

The  most  essential  points  presented  in  this  chapter  regarding  the 
existing  economic  order,  may  now  be  summarized  as  follows :  Indi- 
viduals produce  separately,  and  on  their  own  initiative,  specializing 
in  the  production  of  certain  economic  goods.  These  goods  they  then 
proceed  to  exchange  for  goods  produced  by  others.  And  the  ex- 
changing process,  being  carried  on  competitively,  results  in  the  fixing 
of  those  prices  which  regulate  the  economic  order,  and  which  make 
it  an  order  truly  cooperative. 

ILLUSTRATIVE  PROBLEMS 

1.  Is  it  consistent  with  the  general  character  of  the  present  economic 
order  that  all  the  orange  growers  of  the  country  should  combine   for 
the  marketing  of  that  product?     That  all  grain  raisers  should  combine 
in  the  purchase  of  binding  twine? 

2.  Is  it  consistent  with  the  general  character  of  the  present  order 
that  all  the  locomotive  engineers  of  the  country  should  combine  in  selling 


30  PRINCIPLES  OF  ECONOMICS  [II 

the  services  of  some  of  their  number  to  the  Michigan  Central  Railway  ? 
Would  it  be  any  more  consistent  with  the  present  system  if  this  com- 
bination sold  the  services  of  all  their  number  to  all  the  railroads  acting 
as  a  unit?  Would  the  second  plan  seem  to  you  any  fairer? 

3.  Two  ladies  discussing  the  high  level  of  prices  in  the  winter  of 
1920  agree  in  holding  this  doctrine :  "During  the  last  few  years  pro- 
ducers have  learned  that  they  can  make  more  money  by  keeping  down 
the  output  and  so  raising  prices.    Hence  we  can  be  quite  sure  that  in  the 
future  they  will  pursue  this  policy :  from  now  on  we  shall  commonly  have 
a  shortage  of  wheat  and  fruit  and  other  farm  products."    Criticize  that 
conclusion. 

4.  We  hear  a  great  deal  of  complaint  in  these  days  to  the  effect  that 
dealers,  middlemen,  are  getting  outrageous  profits.     Doubtless  there  is 
always  a  possibility  that  the   unexpected   will   happen;    but,   provided 
competition  is  kept  free,  the  presumption  is  always  against  the  truth  of 
such  an  accusation  as  the  above.    Defend  the  last  statement. 


Ill 

Some  Economic  Principles  Deducible  from  the  General  Nature 
of  the  Present  Order 

Prevalence  of  Economic  Fallacies. — A  notable  fact  in  this  age 
of  general  education  and  enlightenment  is  the  continued  acceptance 
by  a  great  majority  of  persons  of  quite  erroneous  notions  with  respect 
to  several  familiar  and  not  very  difficult  economic  questions.  One  can 
hardly  run  through  a  current  newspaper  or  popular  magazine  without 
coming  upon  fallacies  which,  as  the  economist  looks  at  it,  were  fully 
disposed  of  by  Adam  Smith  almost  a  century  and  a  half  ago.  This 
prevalence  of  unsound  doctrine  is  particularly  troublesome  and  dan- 
gerous in  a  country  like  the  United  States,  because  the  majority  of 
the  people  have  the  power  to  affect  the  policy  of  the  government 
in  economic  matters,  and  frequently  use  that  power.  Accordingly 
one  of  the  greatest  tasks  of  the  student  of  Economics  is  to  train  him- 
self in  the  art  of  detecting  the  fallacies  which  lurk  in  popular  beliefs. 
This  task  confronts  us,  too,  at  the  very  outset  of  our  course ;  for  some 
of  the  most  wide-spread  fallacies  are  concerned  with  facts  already 
brought  out  in  the  foregoing  general  account  of  the  present  economic 


II]  GENERAL  SURVEY  31 

order.    We  will,  therefore,  at  once  set  about  formulating  principles 
and  applying  them  to  popular  errors. 

All  Profit  from  the  Efficiency  of  Each. — The  first  generaliza- 
tion from  the  nature  of  the  present  order  which  we  have  to  lay  down 
is  that,  generally  speaking,  each  person  gains  from  the  increased 
efficiency  of  his  neighbors.  In  one  way  this  would  seem  to  follow 
as  an  evident  corollary  from  the  proposition  already  set  forth,  that 
our  economic  order  is  cooperative.  As  long  as  we  cooperate  in  pro- 
duction, the  efficiency  of  the  persons  producing  all  the  different  com- 
modities will  increase ;  this  will  swell  the  total  product  of  the  group 
and  so  may  naturally  be  expected  to  bring  advantage  to  all  members 
of  the  group,  those  concerned  with  one  commodity  as  well  as  those 
concerned  with  another.  Thus,  when  the  farmer,  carpenter,  and 
mechanic  cooperate — in  the  sense  that  each  specializes  in  his  own 
craft  and  exchanges  his  product  for  those  of  the  others — they  every 
one  obtain  better  goods  and  more  goods  and  goods  of  a  greater  va- 
riety than  they  otherwise  would.  But  in  real  life  there  is  a  more 
difficult  problem.  Suppose  that,  after  cooperation  is  established,  the 
farmer  and  the  carpenter  come  to  a  standstill  in  the  development  of 
their  craft,  while  the  mechanic  proceeds  to  acquire  an  extreme  ef- 
ficiency. It  might  be  argued  that,  although  the  aggregate  product  of 
the  group  will  surely  be  increased,  this  will  not  necessarily  be  of  any 
advantage  to  the  other  members  of  the  group,  because  the  increase 
may  all  go  to  the  person  whose  efficiency  has  risen,  the  mechanic  alone. 

The  Proof. — The  full  answer  to  this  objection  depends  on 
a  knowledge  of  the  principles  of  price  or  value  which  we  do  not  take 
up  till  later  in  our  study.  Still,  it  will  not  be  difficult  to  anticipate 
that  discussion  sufficiently  to  satisfy  the  student's  mind  in  regard  to 
the  general  point,  (i)  If  the  mechanics  learn  to  make  twenty  cars 
a  year  instead  of  ten,  while  farmers  and  carpenters  continue  to  pro- 
duce at  the  same  rate  as  before,  then  under  free  competition  the  ex- 
changing rate  between  autos  on  the  one  hand  and  corn  and  houses 
on  the  other  will  alter  in  favor  of  the  latter.  For  auto-makers,  in 
competition,  will  offer  more  and  more  of  their  increased  supply  of 
cars  against  a  supply  of  corn  and  houses  that  has  not  increased  at  all. 


32  PRINCIPLES  OF  ECONOMICS  [II 

Accordingly,  a  certain  quantity  of  corn  and  houses  will  buy  more 
automobiles  tban  before.  (2)  Since  by  hypothesis  no  change  has 
taken  place  among  the  farmers  and  carpenters,  the  exchanging  rate 
between  their  goods,  corn  and  houses,  will  not  have  altered :  a  certain 
quantity  of  one  will  buy  the  same  quantity  of  the  other  as  before. 
(3)  Consequently,  the  farmer  or  carpenter  will  find  himself  able  to 
buy  with  his  own  product  more  automobiles,  while  buying  no  less 
houses  or  corn.  In  other  words,  he  will  have  gained  from  the  in- 
creased efficiency  of  another  producer. 

It  must  not  be  imagined,  of  course,  that  the  producer  whose  ef- 
ficiency increases  derives  no  advantage  from  that  increase.  A  man 
who  suddenly  runs  far  ahead  of  his  fellows  in  efficiency  may,  before 
competition  can  overtake  him,  reap  enormous  gains ;  and  the  use  of 
secret  processes,  and  the  protection  of  patents  may  for  a  brief  time 
prolong  this  advantage.  Besides,  even  when  competition  is  operating 
freely,  the  efficient  producer  will  commonly  gain.  Each  unit  of 
his  commodity  buys  less  than  before;  but  he  has  more  units  to  buy 
with,  and  usually  this  brings  to  him  an  increased  total  of  other  goods. 
The  point  to  be  emphasized  here,  however,  is  that,  although  the  person 
or  the  class  that  shows  increased  efficiency  may  gain  something  by 
it,  the  public  also  does  not  fail  to  gain.  The  benefits  of  an  improve- 
ment do  not  accrue  permanently  to  the  producer  alone;  they  are 
diffused,  they  go  to  the  public — and,  broadly  speaking,  to  every 
member  of  the  public. 

Formulating  the  point  brought  out  in  the  foregoing  discussion, 
we  have  the  following : 

Principle.  The  present  order  being  a  cooperative  one, 
each  person  or  community  tends  to  gain  from  an  increase  in 
the  economic  efficiency  of  other  persons  or  communities  with 
whom  or  with  which  said  person  or  community  maintains 
economic  relations. 

Real  Functions  of  Trade. — A  second  matter  on  which  we  need 
thus  early  to  lay  down  a  formal  principle  is  the  function  of  trade, 
exchange.  There  is  indeed  almost  no  other  phase  of  Economics  on 


II]  GENERAL  SURVEY  33 

which  popular  opinions  go  so  widely  astray.  In  the  minds  of  a  few 
persons,  all  trade  whatever  is  illegitimate;  to  a  much  larger  number 
this  is  true  of  at  least  some  kinds  of  trade;  and  a  majority  of  persons, 
probably,  believe  that  trade,  if  legitimate  at  all,  is  surely  in  any 
proper  sense  of  the  word,  unproductive.  But  if  the  account  given  in 
this  chapter  of  the  general  features  of  the  economic  order  is  sound, 
all  these  adverse  judgments  are  of  course  quite  untenable.  Trade  in 
general,  and  presumably  all  kinds  of  trade,  are  legitimate  because  they 
play  a  vital,  necessary  role  in  economic  affairs.  Exchange  is,  as  we 
have  seen  before,  of  the  very  essence  of  our  heterogeneous  coopera- 
tion— it  both  effects  and  regulates  that  cooperation — and  the  one 
without  the  other  is  unthinkable.  The  fact  may,  therefore,  be  for- 
mulated in  the  following: 

Principle.  Under  the  existing  economic  system,  ex- 
change (trade,  commerce)  plays  an  essential  part  in  that  it 
makes  possible  economic  cooperation  and  specialisation — 
it  supplies  the  process,  or  system  of  processes,  whereby  co- 
operation is  effected  and  regulated. 

Furthermore,  if  we  understand  by  the  word  "productive"  that 
the  operation  so  characterized  fulfils  a  condition  essential  to  the 
satisfying  of  our  wants,  then  trade  in  some  form,  certainly,  is  pro- 
ductive. 

This  proposition  so  plainly  follows  from  the  principle  that 
it  needs  no  further  proof.  It  gives  us  two  corollaries.  The  first 
concerns  the  function  of  exchange  as  effecting  our  cooperation  and 
may  be  stated  as  follows : 

Corollary  i.  Exchange  operations,  viewed  as  processes 
necessary  to  consummating  our  economic  cooperation,  are 
productive  operations,  and  people  engaged  in  such  operations 
are  producers. 

The  second  corollary,  though  it  follows  quite  as  directly  from 
the  principle,  may  require  some  little  comment.  It  concerns  the 
fact  that  exchange  is  the  regulator  of  our  cooperation.  Many  persons 
who  admit  that  mercantile  operations  are  productive  in  so  far  as 


34  PRINCIPLES  OF  ECONOMICS  [II 

they  are  devoted  to  buying  from  producers  and  selling  to  consumers, 
would  yet  be  disposed  to  deny  the  productivity  of  these  operations  in 
so  far  as  their  function  is  the  determining  of  prices.  But  the  error 
of  such  a  denial  can  readily  be  seen.  As  the  principle  tells  us,  ex- 
change is  responsible  for  the  proper  regulation  of  our  economic 
activities,  and  this  part  of  its  task  is  largely  performed  through  the 
changing  of  price.  It  follows,  then,  that  exchange  operations,  viewed 
merely  as  price-determining  operations,  are  essential  parts  of  the 
total  productive  process,  hence,  are  productive  operations. 

Corollary  2.  Exchange  operations,  viewed  as  processes 
whereby  our  cooperation  is  regulated  through  price,  are  pro- 
ductive operations  and  persons  engaged  in  such  operations 
are  producers. 

ILLUSTRATIVE  PROBLEMS 

1.  "Give  the  farmer  a  parcels  post  to  begin  with.     Let  him  send  his 
dozen  eggs  or  his  pair  of  chickens  direct  to  the  man  who  wants  to  eat 
them,  or  at  least  to  the  retail  merchant.     Cut  out  the  commission  mer- 
chant, the  wholesaler,  and  a  few  other  of  the  city  parasites  that  live  on 
the  farmer." — New  York  Evening  Journal. 

(a)  Suppose  yourself  to  be  a  farmer  living  in  the  neighborhood  of 
Ann  Arbor,  and  point  out  some  advantages  you  would  derive  from  selling 
your  butter  to  the  grocers  and  your  chickens  to  the  meat  men  rather  than 
to  consumers. 

(b)  Suppose  yourself  to  be  a  fruit  grower  in  Western  Michigan,  de- 
pendent for  your  market  chiefly  on  Chicago,  and  point  out  some  dis- 
advantages which  you  would  suffer  if  you  tried  to  sell  grapes,  peaches, 
etc.,  by  parcels  post  to  the  ultimate  consumers  in  Chicago  and  its  vicinity, 
rather  than  to  commission  merchants. 

(c)  Show  that  these  facts  are  inconsistent  with  the  notion  that  com- 
mission merchants,  wholesalers,  et  al.,  are  "city  parasites." 

Note :  There  is  of  course  much  to  be  said  in  favor  of  a  parcels  post ; 
and  it  is  always  possible  that  the  number  of  middlemen  should  become 
needlessly  large  so  that  some  of  them  may  fairly  be  viewed  as  parasites. 
But  such  a  characterization  of  the  class  as  a  whole  is  quite  illegitimate. 

2.  "Internal  commerce  does  not  increase  the  wealth  of  a  nation  since 
it  only  transfers  goods  from  one  person  to  another."     Criticize. 


II]  GENERAL  SURVEY  35 

3.  At  various  times  there  has  been  much  talk  about  the  "right  price" 
for  some  commodity.     On  the  basis  of  the  account  of  the  present  order 
given  in  this  chapter,  what  would  be  a  natural  definition  of  "right  price"  ? 

4.  In  the  natural  course  of  events  it  often  happens  that  a  country 
loses  some  portion  or  the  whole  of  its  market  in  some  particular  country. 
When  this  happens  or  is  anticipated,  public  men  are  apt  to  speak  as  if 
such  a  result  involved  almost  irremediable  disaster.     Doubtless  it  would 
mean  some  loss,  but  by  no  means  the  amount  which  people   seem  to 
imagine.     Explain  precisely  what  would  be  the  nature  of  the  injury  to 
us,  if  our  foreign  trade  should  fall  off  by  a  considerable  amount.     Sup- 
posing our  foreign  market  showed  a  permanent  net  shrinkage  of  200  mil- 
lions of  dollars  per  annum,  would  this  mean  that  our  yearly  income  would 
be  200  millions  smaller?     If  not,  just  what  would  it  mean? 

5.  From  the  Congressional  Record  for  May  17,  1909:    "Mr.  Aldrich. 
Assuming  that  the  price  fixed  by  the  reports  is  the  correct  one,  if  it 
costs  10  cents  to  produce  a  razor  in  Germany  and  20  cents  in  the  United 
States,  it  will  require  100  per  cent  duty  to  equalize  the  conditions  in  the 
two  countries.  .  .  .  And,  so  far  as  I  am  concerned,  I  shall  have  no  hesi- 
tancy in  voting  for  a  duty  which  will  equalize  the  conditions.  .  .  . 

"If  it  was  necessary  to  equalize  the  conditions,  ...  I  would  vote  for 
300  per  cent  as  cheerfully  as  I  would  for  50." 

To  what  sort  of  an  economic  system  would  such  notions,  if  logically 
carried  out,  inevitably  lead? 

6.  "A  first-class  illustration  of  the  absurdity  and  wrong  of  the  pres- 
ent order  is  furnished  by  the  case  of  a  plumbing  firm.     Such  a  firm  does 
little,  if  anything,  more  than  act  as  a  middleman  between  the  actual 
plumbers  and  householders.     But  it  pays  the  former  at  the  rate  of,  say, 
30  cents  an  hour  for  their  services,  while  it  charges  householders  60 
cents  an  hour  for  those  services.     Here  you  have  a  plain  case.     Either 
the  firm  underpays  the  laborers  or  overcharges  the  householders ;  and 
in  either  case  it  gets  something  which  it  has  no  right  to.     There  is  no 
other  alternative."     Discuss  the  above. 

7.  "If  the  wheat  crop  of  the  world  should  fall  off  one-half  next  year, 
a  rise  in  price  would  then  be  of  great  social  advantage."     Explain. 

8.  The  general  account  of  the  existing  economic  order  which  has 
been  given  in  the  present  chapter  furnishes  one  of  the  most  fundamental 
objections  to  the  maintenance  of  a  protective  tariff,  i.e.,  a  tariff  intended 
to  hinder  our  buying  goods  from  other  countries.     Explain  that  objection. 


CHAPTER  III 

AUTHORITATIVE  CONTROL  IN  THE  EXISTING 
ECONOMIC  ORDER 

We  have  thus  far  described  the  present  economic  order  as  built 
up  and  regulated  by  the  free,  spontaneous  action  of  men.  This 
description  is,  in  the  main,  correct ;  and  it  emphasizes  the  fact  which 
we  should  first  of  all  fix  clearly  in  mind.  There  is  an  economic 
order  of  a  perfectly  definite  sort,  organized  in  a  highly  intricate  way, 
and,  in  spite  of  its  apparent  surface  contradictions,  tending  to  supply 
man's  wants  with  an  efficiency  truly  marvelous  to  those  who  have 
never  before  reflected  upon  the  fact;  and  this  order,  in  its  most 
essential  features,  owes  its  existence  and  its  regulation  to  the  free 
action  of  men  pursuing  their  own  personal  economic  interests. 

Not  Purely  Spontaneous. — In  saying  this,  however,  we  by  no 
means  present  a  complete  and  accurate  picture  of  the  existing  order. 
There  never  was,  and  is  not  now,  an  economic  order  purely  spon- 
taneous. The  spontaneous  action  of  men  in  their  economic  relations 
has  always  been  more  or  less  influenced,  either  in  the  way  of  help  or 
hindrance,  by  authoritative  forces  outside  the  men  themselves.  Some- 
times mere  public  opinion  or  a  general  social  custom  has  made  itself 
felt.  Sometimes  a  powerful  religious  organization  has  said  that  men 
should  do  thus  and  so,  and  has  compelled  them  to  do  it.  But  the 
strongest  of  all  authoritative  forces  outside  the  individual,  especially 
in  the  present  age,  is  the  action  of  organized  government.  To  this 
aspect  of  the  existing  order,  we  must  give  something  more  than  pass- 
ing attention.  First,  then,  we  comment  briefly  on  some  governmental 
activities  which  may  be  looked  on  as  logically  essential  to  the  realiza- 
tion of  the  principle  dominant  in  the  present  order.  Later  we  will 
remark  on  several  kinds  of  governmental  activities  which  are  more 
or  less  inconsistent  with  the  central  principle  of  our  order,  but  which 
are,  after  all,  by  many  or  most  authorities  thought  desirable. 

36 


Ill]  AUTHORITATIVE  CONTROL  37 


Activities  Essential  to  the  Realization  of  the  Central  Principle 
of  the  Present  Order 

Free  Initiative. — One  type  of  governmental  activity  vkally 
essential  to  the  present  order  insures  the  possession  by  a  considerable 
number  of  persons  of  the  right 'of  free  initiative.  This  proposition 
is  immediately  deducible  from  the  fundamental  character  of  the 
present  order.  That  order,  we  remember,  depends  on  the  initiative, 
the  spontaneous  action,  of  the  individual  to  see  that  the  right  things 
and  the  right  quantities  of  things  are  produced ;  and,  at  the  same  time, 
it  expects  individuals  to  exercise  this  function  under  conditions  of 
competition.  Naturally,  then,  it  will  be  necessary  for  people  gener- 
ally to  possess  the  right  of  initiative;  Further,  since  this  right  might 
easily  be  hampered  by  the  voluntary  action  of  other  individuals,  it  is 
necessary  that  the  state  should  make  special  provision  to  insure  its 
maintenance.  The  government  must,  for  example,  do  its  utmost  to 
eliminate  what  is  known  as  monopoly, — the  control  by  one  will  of 
economic  activity,  especially  the  production  or  sale  of  any  kind  of 
goods. 

Right  of  Property. — Again,  governmental  action  is  vitally 
needed  to  insure  that  individuals  shall  have  the  power  to  get  control 
of  the  instruments  of  industry,  the  raw  materials,  tools,  machines, 
etc.,  including  the  services  of  those  human  beings  who  assist  in  the 
productive  process;  for,  obviously,  production  cannot  be  initiated 
and  carried  forward  by  the  spontaneous  action  of  individuals,  unless 
they  have  this  power.  Our  present  economic  order,  in  some  of  its 
variations,  has  allowed  full  property  in  all  these  factors  to  the  private 
individual.  At  times  it  has  permitted  him  to  own  land,  materials, 
tools,  and  even  the  human  beings  who  give  off  productive  services. 
In  the  present  age,  as  we  know,  property  in  human  beings  is  almost 
universally  forbidden ;  but  in  the  other  instruments  of  production  it 
is  almost  as  universally  recognized.  This  private  ownership  is  not 
strictly  a  necessity.  The  state  might  own  the  instruments  while  the 
men  who  initiate  and  maintain  production  merely  buy  from  it  the 


38  PRINCIPLES  OF  ECONOMICS  [III 

services  of  those  instruments;  and  yet  the  fundamental  principle  of 
our  order  would  be  successfully  carried  out.  In  any  case,  however, 
it  would  be  necessary  that  individuals  should  have  the  power  named, — 
the  power  to  control  and  dispose  of  these  services — else  they  certainly 
could  not  initiate  and  guide  economic  activities. 

But  not  only  does  the  present  system  require  that  individuals 
shall  have  the  right  to  control  instruments  of  production,  it  is 
possible  that  the  right  will  be  infringed  by  the  action  of  other  indi- 
viduals. Superior  force  or  guile  may  greatly  impair  the  efficiency  of 
the  system  approved  by  the  public  will.  It  follows  that  governmental 
action  is  needed  to  insure  the  possession  by  the  individual  of  these 
necessary  property  rights.  Whatever  degree  of  control  over  the 
instruments  of  production  we  purpose  to  grant  to  the  individual, 
that  control  we  must  insure  to  him  by  governmental  action.  Simi- 
larly, the  government  should,  of  course,  insure  that  the  man 
responsible  for  the  production  of  economic  goods  shall  be  secure  in 
his  right  to  the  ownership  of  those  goods  after  he  has  produced  them. 
For  other  persons  might  be  disposed  and  able  to  deprive  him  of  the 
fruits  of  his  efforts,  thus  destroying  the  motive  for  industry;  and 
this  possibility  can  be  shut  out  only  by  the  action  of  the  government. 

Right  of  Contract. — Another  type  of  governmental  action 
essential  to  the  conduct  of  the  present  order  is  the  authorization  and 
maintenance  of  contracts.  Individuals  must  be  permitted  to  make 
agreements  with  one  another  in  respect  to  their  economic  conduct, 
and  the  government  must  provide  for  the  enforcement  of  these  agree- 
ments. This  necessity  grows  out  of  two  facts:  (i)  Many  economic 
operations  require  extended  periods  of  time,  and  (2)  in  many  cases 
the  carrying  out  of  the  time-consuming  process  requires  a  dependable 
anticipation  of  future  needs.  If  a  man  is  building  a  house,  he  will 
need  material  and  labor  at  various  times  during  a  considerable  period 
in  the  future ;  and,  for  obtaining  these,  he  cannot  safely  trust  to  the 
chance  of  the  moment.  To  secure  something  like  certainty,  he  makes 
contracts  in  advance.  Again,  as  we  all  know,  one  of  the  chief  factors 
in  production,  capital,  is  largely  obtained  by  borrowing  from  others. 
And  this  involves  a  contract,  in  that  the  borrower  must  agree  to 
return  the  sum  borrowed  and  pay  interest  for  its  use. 


Ill]  AUTHORITATIVE  CONTROL  39 

But,  if  it  is  practically  necessary  to  have  a  right  of  contract  in 
carrying  out  the  principle  of  the  existing  order,  it  is  also  necessary  at 
this  point  to  have  some  action  of  the  government ;  for,  without  gov- 
ernmental interference,  the  right  of  contract  could  not  be  effectively 
maintained.  Circumstances  would  always  be  arising  in  which  it  was 
for  the  interest  of  one  or  the  other  of  the  parties  to  break  the  contract ; 
and  all  experience  shows  that  the  temptation  is  too  powerful  for 
human  nature  unless  restrained  by  the  strong  hand  of  the  law.  Our 
economic  system,  therefore,  requires  that  the  government  shall  au- 
thorise and  enforce  contracts. 

Free  Exchange. — Again,  it  is  plain  that  governmental  au- 
thority is  needed  to  insure  the  right  of  free  exchange.  As  we  saw 
in  the  preceding  chapter,  one  of  the  most  central  features  of  the 
present  order  is  a  type  of  cooperation  effected  and  regulated  through 
exchange.  The  existence  of  a  general  freedom  of  exchange  is,  there- 
fore, an  absolute  sine  qua  non.  But  this  freedom  is  always  liable  to 
be  infringed  by  the  selfish  action  of  other  individuals.  Dealers  them- 
selves are  eager  to  eliminate  competition  and  often  try  to  do  so  by 
agreements  of  a  monopolistic  character.  The  necessary  freedom  of 
exchange,  then,  can  be  insured  only  by  the  potent  interference  of  gov- 
ernment. The  state  may  conclude  that  for  reasons  of  a  public  nature 
it  is,  on  the  whole,  undesirable  to  maintain  perfect  freedom  in  every 
field ;  but  it  should  insure  such  freedom  for  economic  action  in  gen- 
eral, and  it  should  see  that  no  interference  with  that  freedom  is 
permitted  except  what  it  authorises. 

ILLUSTRATIVE  PROBLEM 

Weak,  tyrannical,  or  corrupt  governments  are  each  unfavorable  to 
high  economic  efficiency.  Why? 

II 
Activities  Designed  to  Increase  Economic  Efficiency 

We  come  now  to  several  forms  of  governmental  activity  which 
cannot  be  described  as  logically  essential  in  carrying  out  the  funda- 
mental principle  of  the  present  order.  They  usually  involve  limita- 
tions upon  that  principle.  They  have  often  been  opposed  by  rigid 


40  PRINCIPLES  OF  ECONOMICS  [III 

supporters  of  the  present  order,  but,  in  the  course  of  the  last  century, 
have  notably  increased  in  all  fields.  Here  we  note,  first  those  activities 
which  attempt  to  improve  the  present  order  by  supplementing  indi- 
vidual action  with  more  efficient  governmental  action.  Not  a  few  of 
this  sort  have  been  carried  on  by  government  in  all  ages,  so  that  they 
are  looked  on  by  almost  every  one  as  belonging  essentially  to  the 
governmental  sphere,  for  example,  the  issue  of  the  money  which 
acts  as  a  medium  of  exchange,  the  building  of  roads,  or  the  making 
of  canals. 

Another  type  of  activity  contributing  to  the  efficiency  of  pro- 
duction which  has  greatly  increased  in  our  day,  is  the  conduct  of 
investigation  into  the  conditions  and  methods  of  procedure  necessary 
to  highest  technical  efficiency.  Thus  public  bureaus  are  maintained 
to  carry  on  research  in  biological  subjects,  like  the  breeding  and  care 
of  animals,  the  improvement  of  seed,  the  discovery  of  better  condi- 
tions for  growth,  etc.  An  activity  closely  allied  to  this  last  is  the 
dissemination  of  information  among  those  engaged  in  an  industry, 
most  conspicuously  those  engaged  in  agriculture.  Still  another  con- 
sists in  providing  for  technical  education  and  training  through  schools 
of  agriculture,  mining,  manufacture,  and  commerce. 


Ill 

Activities  Designed  to  Alter  the  Distribution  of  Property  and 

Income 

It  has  always  been  recognized  that  the  present  system  needs  to  be 
supplemented  by  governmental  action  not  only  to  increase  its  ef- 
ficiency, but  also  to  prevent  undesirable  consequences  which  the  free 
working  of  the  system  would  inevitably  produce.  One  such  con- 
sequence is  extreme  inequality  in  respect  to  the  distribution  of 
property  and  income.  In  spite  of  the  high  efficiency  of  the  system 
as  a  whole,  many  people  feel  that  we  cannot  rest  content  until  we 
have  ameliorated  the  inequality  resulting  from  it.  And  at  this  point 
the  intervention  of  government  is  demanded. 

Among  the  various  policies  used  by  government  to  improve  the 
system  of  distribution,  we  have  the  guidance  of  taxation  in  a  way  to 


Ill]  AUTHORITATIVE  CONTROL  41 

throw  the  chief  burden  on  the  wealthier  classes.  In  other  fields,  a 
particular  kind  of  service  is  sold  to  everyone  at  the  same  price, — 
the  rich  man  and  the  poor  man  pay  the  same  for  a  loaf  of  bread  or  a 
pound  of  meat.  But,  since  the  fundamental  services  supplied  by 
government  have  no  price  to  rich  or  poor  while  the  cost  of  main- 
taining government  falls  more  heavily  on  the  rich,  the  latter  virtually 
pay  a  higher  price  for  these  services  than  do  the  poor.  In  effect, 
then,  the  system  of  taxation  redistributes  the  social  income  in  favor 
of  the  poor. 

In  speaking  above  of  the  attempt  to  relieve  less  wealthy  people  of 
the  tax  burden,  we  had  in  mind  especially  that  volume  of  taxes  which 
is  bound  to  be  levied  because  it  is  destined  to  meet  the  necessary 
expenses  of  government.  A  second  method  of  diminishing  inequality 
also  involves  the  system  of  taxation,  but  in  a  different  way.  Govern- 
ment undertakes  to  improve  the  condition  of  people  of  small  or  mod- 
erate means  by  furnishing  certain  services  and  goods  either  gratui- 
tously or  at  a  price  lower  than  would  appear  under  the  operation  of 
free  private  initiative ;  and  the  funds  needed  to  meet  the  expense  for 
these  types  of  activity,  like  the  ordinary  income  of  government,  are 
raised  by  taxation,  assessed  according  to  wealth;  so  that  the  net 
result  is  a  redistribution  of  income  favorable  to  all  but  the  wealthy 
classes. 

The  most  familiar  example  of  this  kind  of  governmental  inter- 
ference is  found  in  the  field  of  education.  Poor  people  lack  money 
to  give  their  children  an  education ;  the  state  undertakes  to  provide  it 
for  them.  In  respect  to  the  simpler  forms  of  education,  this  policy 
dates  back  a  long  way;  but  in  our  day  it  has  been  extended  also  to 
the  more  advanced  forms.  Intermediate,  and  even  the  very  highest 
cultural  courses,  as  also  technical  or  vocational  training,  are  open  to 
all  classes,  if  not  gratuitously,  at  least  below  cost.  The  children  of 
the  poor,  as  a  result,  have  opportunities  many  times  greater  than  they 
could  expect  in  an  order  purely  spontaneous.  Supposing  their 
natural  endowment  adequate,  they  may  hope  to  attain  the  highest 
professional  positions  of  all  sorts.1 


1  The  student  is  of  course  aware  that  much  of  this  sort  of  work  is  done 
by  the  voluntary  contributions  of  the  rich ;  but  we  are  here  concerned  only 
with  the  activity  of  government. 


42  PRINCIPLES  OF  ECONOMICS  [III 

Another  line  of  governmental  activity  concerned  with  bettering 
the  condition  of  the  poorer  classes  and  so  in  effect  redistributing  the 
social  income,  looks  after  defectives, — the  maimed,  the  blind,  the 
insane,  the  feeble-minded — either  in  part  or  in  whole  at  public  ex- 
pense. The  wealthy  could  afford  to  provide  for  this  themselves,  the 
poor  could  not.  Again,  the  government  often  manages  certain  in- 
dustries which  furnish  fundamental  necessities  such  as  water,  gas, 
and  electric  current,  in  order  to  help  the  poor  by  supplying  these  at 
lower  prices  than  would  appear  under  private  initiative.  In  Europe 
a  number  of  municipalities  have  gone  so  far  as  to  undertake  the 
running  of  street  car  lines,  charging  fares,  especially  for  working- 
men,  below  the  cost  of  the  service.  Still  again,  governments  improve 
the  condition  of  the  less  well-to-do  by  maintaining  institutions  for 
supplying  all  classes  with  forms  of  entertainment  which  would  natur- 
ally be  open  only  to  the  rich.  This  is  illustrated  in  the  maintenance 
of  free  public  libraries,  picture  galleries,  opera  houses,  parks,  and 
playgrounds. 

ILLUSTRATIVE  PROBLEMS 

1.  In  what  other  way  than  that  given  on  pages  41  and  42  can  the 
governmental  provision  of  education  for  the  masses  be  justified? 

2.  Argue  that  it  would  be  better  to  use  the  method  described  on 
page  41  for  promoting  the  welfare  of  the  poorer  classes  rather  than  a 
method  which  tried  to  alter  their  incomes  directly,  that  is,  by  raising  the 
rate  of  wages. 

IV 

Activities  Designed  to  Secure  Some  Advantage  of  the  Social 
Group  as  a  Whole 

In  the  last  section  we  dealt  with  activities  designed  to  improve  the 
condition  of  the  poorer  classes.  All  such  activities  may  be  and  doubt- 
less are  inspired  in  part  by  another  motive,  the  desire  to  improve  the 
condition  of  the  group  as  a  whole — the  city,  the  state,  the  nation. 
For  surely  any  group  which  hoped  to  prosper  as  a  whole  would  see 
to  it  that  taxes  were  levied  with  relatively  less  weight  upon  the  poor, 
that  defectives  were  cared  for,  and  that  education  for  all  was  pro- 


Ill]  AUTHORITATIVE  CONTROL  43 

vided.  The  foremost  motive  in  all  these  activities,  however,  is 
perhaps  the  welfare  of  the  classes  or  of  the  individuals  who  are 
directly  aided.  We  come  now,  on  the  other  hand,  to  a  type  of 
activity  motivated  mainly  if  not  entirely  by  the  desire  to  improve 
the  welfare  of  the  group  as  a  whole;  a  type  intended  not  to  guard 
the  individual,  but  to  guard  the  group  against  the  evils  which  might 
result  from  the  unhindered  working  of  the  present  system.  It  may 
be  true,  as  has  been  implied"  in  much  of  our  earlier  discussion,  that 
for  all  individuals  everywhere  an  absolutely  spontaneous,  automatic 
workings  of  things  would  be,  on  the  whole,  best.  In  that  case  a  man 
whom  we  should  describe  as  thoroughly  cosmopolitan  in  spirit,  one 
who  is  interested  in  all  humanity,  would  find  in  such  regulation  the 
highest  possible  ideal.  But  this  description  applies  to  very  few  of  us 
indeed.  Oftentimes  we  are  not  interested  in  the  welfare  of  indi- 
viduals everywhere,  nor  even  in  our  own  immediate  welfare,  or  in 
that  of  people  directly  dependent  upon  us,  so  much  as  we  are  inter- 
ested in  the  success  and  greatness  of  the  city,  state,  or  nation  to  which 
we  belong.  Further,  the  welfare  of  an  individual  is  not  necessarily 
consistent  with  that  of  his  group;  there  is  a  possible  antithesis  be- 
tween the  welfare  of  the  individuals  constituting  a  group  and  that  of 
the  group  considered  as  a  whole.  Hence,  if  any  group  of  men  comes 
to  believe  that  the  free,  automatic  regulation  of  economic  relations 
between  their  own  group  and  other  groups  (although  best  for  them 
as  individuals  and  for  all  individuals  everywhere)  hinders  the  ac- 
complishment of  some  good  greatly  important  for  their  own  group, 
they  will  naturally  insist  upon  interfering  with  this  automatic  regu- 
lation, and  insist  on  resorting  to  conscious  control  through  the  power 
of  the  state. 

National  Power  and  Independence. — The  chief  application  of 
the  idea  just  set  forth  arises  in  connection  with  the  problem  of 
maintaining  the  independence  and  power  of  the  nation  over  against 
its  neighbors.  The  efficiency  of  a  state  at  this  point  manifestly  de- 
pends on  economic  as  well  as  on  purely  military  considerations.  A 
nation  needs  to  be  wealthy;  it  needs  to  have  great  capacity  for  the 
production  of  the  instruments  of  war;  it  needs  to  be  insured  the 
forthcoming  of  the  fundamental  necessities  of  life  in  case  it  should 


44  PRINCIPLES  OF  ECONOMICS  [III 

through  the  fortunes  of  war  be  cut  off  from  its  usual  sources  of 
supply.  Now  it  is  perfectly  possible  that  the  spontaneous  working 
of  economic  forces  should  result  in  neglect  in  some  of  these  fields. 
The  natural  resources  of  the  nation  may  be  chiefly  agricultural;  so 
that  the  unrestricted  pursuit  of  private  gain  may  hinder  the  nation 
from  developing  the  manufacturing  industries  and  so  render  it  un- 
prepared to  supply  itself  with  the  manufactured  goods  needed  for 
war.  On  the  other  hand,  it  may  naturally  be  an  exclusively  manu- 
facturing or  commercial  nation,  obtaining  its  supplies  of  food  from 
other  countries.  The  pursuit  of  private  gain  may  then  fail  to  develop 
sufficiently  some  industry  on  which  its  very  life  depends. 

The  possibility  that  unrestricted  private  initiative  may  thus  ex- 
pose a  nation  to  complete  destruction  if  cut  off  by  war  from  its 
ordinary  sources  of  supply  has  led  governments  to  put  high  taxes  on 
the  importation  of  foreign  goods,  thus  raising  their  prices  and  so 
making  more  profitable  the  producing  of  similar  goods  at  home. 
Legislation  has  been  used,  likewise,  to  develop  important  forms  of 
manufacture ;  so  that  we  find  almost  all  nations  erecting  tariff  barriers 
to  shut  out  the  products  of  their  neighbors  and  stimulate  the  home 
pursuit  of  the  same  industries. 

Interests  of  Posterity. — We  have  commented  on  those  activi- 
ties of  the  state  which  are  designed  to  protect  a  group  as  a  whole 
against  other  groups  by  avoiding  the  economic  weaknesses  likely  to 
result  from  individual  action  in  economic  matters.  Another  set  of 
injuries  growing  out  of  individual  liberty  is  associated  with  the  dissi- 
pation of  our  primary  resources  in  land,  raw  materials,  etc.  Ex- 
perience has  shown  that  private  self-interest  cannot  be  trusted  to 
conserve  the  stores  of  coal,  iron  ore,  copper,  oil,  and  timber  which 
constitute,  so  to  speak,  the  patrimony  of  the  nation.  It  is  essential, 
therefore,  for  the  welfare  of  the  nation  as  a  whole,  that  government 
should  step  in  with  a  policy  of  conservation,  well  planned  and  strictly 
enforced.  Similar  to  this  case,  and  even  more  important,  is  the 
conservation  of  the  life,  health,  and  strength  of  the  people  themselves. 
Unrestricted  private  freedom  in  business  has  meant  an  exploitation 
of  the  strength  and  capacity  of  working  people,  especially  women 
and  children,  quite  inconsistent  with  the  welfare  of  the  group  as  a 


Ill]  AUTHORITATIVE  CONTROL  45 

whole.  As  a  consequence,  there  has  developed  through  a  century  of 
agitation  and  legislation  a  great  body  of  statutes  designed  to  guard 
the  productive  population  against  the  evil  effects  of  excessive  and 
unsuitable  labor  in  unsanitary  conditions. 

Summary. — To  sum  up  the  contents  of  this  chapter:  Upon 
the  economic  order  described  in  the  last  chapter  as  one  of  cooperation 
automatically  effected  and  regulated  by  exchange,  we  find  at  many 
points  the  influence  of  conscious  regulation  directed  by  government. 
Certain  activities  of  government  in  enforcing  the  right  of  free  initia- 
tive, private  property,  contract,  and  exchange,  are  necessary  to  allow 
the  automatic  principle  to  work  itself  out  in  any  really  effective 
manner.  The  government  also  acts  at  various  points  in  contradiction 
of  the  principle,  in  order  to  increase  our  economic  efficiency,  or  to 
better  the  economic  condition  of  certain  classes  or  to  secure  the 
safety  and  welfare  of  the  nation  as  a  whole. 

The  emphasis  we  have  put  upon  these  modifications  should  not, 
however,  lead  us  to  overlook  the  fact  that  they  are,  after  all,  modifi- 
cations and  that  only.  The  great  essentials  of  the  economic  order  at 
present  existing  are  not  these  things  but  the  things  we  described  in 
the  last  chapter.  The  present  order  is  in  the  main  one  in  which, 
through  the  spontaneous  action  of  the  individual  pursuing  his  immedi- 
ate self-interest,  there  arises  cooperation  of  a  highly  advantageous 
sort,  effected  and  regulated  by  exchange.  It  is  that  spontaneously 
developed  organization  or,  better,  organism,  which  constitutes  the 
real  framework  of  our  system.  And  it  is  that  organism  which  in  the 
further  study  of  this  course  we  should  keep  most  prominently  in 
mind. 


CHAPTER  IV 
ANALYSIS  OF  PRODUCTION 

The  central  fact  of  economics,  as  heretofore  pointed  out,  and  the 
starting  point  for  all  thinking  on  economic  matters,  is  man's  wants. 
These  wants,  as  we  have  also  seen,  are  supplied  by  things  called 
economic  goods,  which  take  the  form  either  of  commodities  or 
services.  Now,  a  very  little  reflection  will  convince  anyone  that 
practically  all  economic  goods  become  possessed  of  their  capacity  to 
satisfy  wants  through  the  action  of  men.  Fish  may  grow  in  the  sea 
and  fur  on  the  animal's  back  and  trees  in  the  forest;  but,  strictly 
speaking,  these  objects  do  not  become  commodities  suitable  for  appli- 
cation to  our  wants  till  they  have  been  appropriated,  shaped,  or  other- 
wise worked  upon  by  forces  directly  manipulated  by  man.  The  same 
is  even  more  obviously  true  of  services,  for  in  case  of  something  like 
a  lecture  or  a  song,  the  very  substance  of  the  thing  which  gives 
satisfaction  appears  not  to  come  into  existence  until  the  lecturer  or 
singer  puts  forth  his  effort.  This  process  of  preparing  goods  for 
the  satisfaction  of  wants  is  called  production.  Accordingly,  since 
our  wants  are  so  urgent  and  since  nearly  all  goods  are  necessarily  so 
prepared,  production  must  be  recognized  as  one  of  the  most  important 
divisions  of  the  study  of  Economics. 


What  Is  It  to  Produce? 

To  begin  with,  what  do  we  mean  by  the  term  "produce"?  In 
everyday  language,  the  word  is  used  in  several  different  senses,  some 
of  which  are  very  broad,  and  some  quite  narrow ;  and  in  the  present 
study,  we  may  at  times  allow  ourselves  a  similar  freedom.  In  the 
interests  of  clear  exposition,  however,  it  is  best  at  the  outset  to  adopt 
a  meaning  which  we  shall  expect  to  have  in  mind  when  we  speak,  as 

46 


IV]  ANALYSIS  OF  PRODUCTION  47 

economists,  with  the  strictest  scientific  accuracy.  Such  a  meaning 
may  be  expressed  as  follows  : 

To  produce  is  to  make  some  contribution  to  the  satisfying  of 
human  wants,  whether  this  be  done  by  persons  or  things,  providing 
such  contribution  has  a  value  or  price. 

Two  parts  of  this  definition  need  a  little  emphasis :  that  the  con- 
tribution made  must  assist  in  satisfying  human  wants,  and  that  it 
must  have  a  value  or  price — in  other  words,  must  have  an  economic 
character.  In  the  light  of  previous  discussions  we  shall  need  few 
words  to  justify  the  second  of  these  qualifications.  We  are  studying 
economics,  not  physical  science.  The  sort  of  production  we  are 
concerned  with  is  economic,  not  physical,  production.  But  economics, 
as  such,  takes  account  only  of  those  things  which  have  value  or 
price,  and  accordingly  our  definition  of  economic  production  is  re- 
stricted to  acts  or  conditions  which  have  a  price. 

Creates  Only  Utilities. — The  first  part  of  our  definition  will 
require  more  careful  examination.  Any  valuable  act  or  thing  that 
makes  a  contribution  to  the  satisfying  of  human  wants  is  productive ; 
but  what  does  it  really  mean  to  make  such  a  contribution?  Since 
wants  are  all  supplied,  in  the  last  analysis,  through  material  goods, 
it  must  mean  to  be  responsible  in  some  sense  or  degree  for  the  exist- 
ence of  material  goods  having  the  qualities  essential  for  our  satis- 
faction. But,  to  pursue  the  question  further,  how  can  a  man  be 
responsible  for  the  existence  of  any  material  object  of  want-supplying 
qualities?  He  cannot  create  the  ultimate  substance  of  an  object,  for 
all  matter  exists  and  always  will  exist  in  some  form  without  his  will 
or  sanction.  His  contribution  must,  therefore,  consist  merely  in 
bringing  substances  or  materials  which  already  exist  into  such  a 
condition  that  they  are  capable  of  satisfying  wants.  Hence,  since  the 
capacity  to  satisfy  wants  is  called  Utility,  we  may  say  that  to  produce 
is  to  create  utilities — the  contributing  act  or  thing  being  always  un- 
derstood to  have  value. 

Kinds  of  Utility. — The  emphasis  laid  on  utility  in  the  above 
analysis  makes  desirable  some  further  comments  on  this  term.  First, 
as  the  word  is  employed  by  economists  it  includes  many  different 


48  PRINCIPLES  OF  ECONOMICS  [IV 

kinds  of  "fitness  to  satisfy  wants."  Thus,  we  have  the  fitness  which 
inheres,  so  to  speak,  in  the  economic  object :  an  elementary  utility,  as 
for  example  in  the  mere  substance  of  copper;  and  a  form  utility, 
illustrated  when  that  copper  has  been  drawn  into  wire  and  prepared 
for  carrying  an  electric  current.  Besides  this  inherent  fitness,  we 
have  the  fitness  which  consists  in  the  relations  of  the  economic  object 
to  men.  Thus  a  loaf  of  bread  situated  where  it  is  wanted  is  more 
useful  than  an  exactly  similar  one  situated  where  it  is  not  wanted, 
and  accordingly  the  economist  talks  of  place  utility;  ice  which  is 
preserved  from  the  cold  months  when  it  is  not  wanted  till  the  warm 
ones  when  it  is  wanted,  assumes  what  we  call  a  time  utility;  and  a 
commodity  passing  from  the  hands  of  a  person  who  has  no  need  of 
it  to  those  of  one  who  does  have  such  need,  acquires  an  ownership 
utility. 

Again,  it  should  be  noted  that  utility  includes  all  sorts  of  fitness 
to  satisfy  wants,  without  respect  to  the  character  of  the  wants. 
Thus,  the  fitness  of  coal  to  warm  one  is  utility  and  the  fitness  of 
bread  to  nourish  one ;  but  the  fitness  of  diamonds  to  give  one  aesthetic 
enjoyment  or  even  of  whiskey  to  give  vicious  enjoyment  is  also 
utility — to  the  economist,  diamonds  and  whiskey  are  just  as  truly 
useful  as  coal  or  bread.  This  of  course  does  not  mean  that  the 
economist  holds  different  ideas  from  other  people  as  to  the  relative 
importance  of  necessaries  and  luxuries  or  as  to  the  undesirableness 
of  using  intoxicants.  But  in  his  terminology  he  must  recognize  the 
common  element  in  diamonds,  whiskey,  bread  arid  all  other  economic 
objects  which  fits  them  to  satisfy  human  wants;  and  utility  is  the 
word  which  he  has  adopted  for  this  purpose. 

Producer  Does  Not  Create  Value. — Another  point  to  be  noted 
before  we  leave  this  general  topic,  the  meaning  of  "produce,"  is  that 
producing  should  not  be  understood  to  mean  creating  value.  Since 
it  is  the  producing  of  wealth  that  we  are  talking  about,  and  since 
wealth  has  value,  it  might  seem  that,  to  produce,  one  must  be  re- 
sponsible for  the  existence  of  value.  But  this  is  a  mistake.  The 
producer  as  such  is  not  responsible  for  every  element  in  wealth  but 
only  for  the  element  of  utility.  His  task  is  to  do  whatever  needs  to 
be  done  to  insure  that  objects  or  conditions  shall  be  fitted  to  satisfy 


IV]  ANALYSIS  OF  PRODUCTION  49 

man's  wants.  Now,  this  must,  of  course,  be  done  before  the  objects 
or  conditions  will  have  value.  In  doing  it,  therefore,  the  producer 
contributes  to  the  process  whereby  value  comes  into  existence.  But 
he  is  not  wholly  responsible  for  the  result.  The  existence  of  value 
requires  the  fulfilment  of  two  conditions:  (i)  that  the  thing  having 
value  shall  be  useful  and,  therefore,  wanted,  and  (2)  that  it  shall, 
for  one  reason  or  another,  be  scarce, — limited  in  amount  as  compared 
with  what  is  wanted.  The  productive  process  fulfils  the  first  of 
these  conditions.  But,  in  so  far  as  the  fulfilment  of  the  second  de- 
pends on  the  productive  process,  it  is  the  necessity  for  that  process, 
not  its  carrying  out,  which  does  the  work.  Because  we  must  produce 
things  if  they  are  to  exist,  because  our  capacity  to  do  this  is  limited 
as  compared  to  our  wants,  and  probably,  also,  because  production 
involves  sacrifices,  the  amount  is  certain  not  to  be  adequate  to  the 
satisfying  of  all  our  wants.  As  a  result  the  things  produced  are 
certain  to  have  value.  But  this  result  the  producer,  per  se,  has  not 
brought  about.  To  the  extent  of  his  capacity  and  inclination,  he  has 
neutralised  one  of  the  conditions,  namely,  the  scarcity  of  the  product. 
And  this  is  his  function  as  a  producer.  His  business  is  to  give  things 
the  capacity  to  satisfy  wants  and  so  the  capacity  to  call  forth  demand. 
That  these  things,  after  all,  are  scarce  and  so  command  a  price  is  due 
to  conditions  not  resulting  from  the  productive  act.1  Perhaps  the 
most  convincing  argument  on  this  point  is  that  the  producer  could 
best  contribute  to  the  fulfilling  of  the  scarcity  condition  of  value  by 
acts  sharply  opposed  to  the  productive  act,  namely,  by  refraining 
from  production  or  even  by  actually  destroying  goods. 

The  Utilities  Must  Have  Value. — Having  emphasized  in  the 
preceding  paragraph  the  point  that  we  do  not  produce  value,  but  only 
utilities,  we  must  hasten  to  warn  the  student  against  a  possible  mis- 
understanding. The  productive  act  as  such  is  responsible  for  utilities 
only.  Nevertheless,  in  the  long  run,  every  productive  act  which  has 
an  economic  character  must  have  a  representative,  an  element  corre- 
sponding to  itself,  in  the  value  of  the  product.  To  illustrate,  the 
raising  of  wheat  requires  land,  sunshine,  rain,  seed,  the  labor  of 


1  We  assume,  however,  that  those  conditions  are  fulfilled.     See  page  47. 


50  PRINCIPLES  OF  ECONOMICS  [IV 

plowmen,  and  so  on,  many  conditions  and  factors,  of  which  factors 
some,  like  the  sunshine  or  the  rain,  are  not  counted  as  economic  at 
all,  since  they  are  outside  human  control  or  for  some  other  reason  do 
not  have  a  price,  while  others,  like  labor,  are  economic,  as  clearly 
indicated  by  their  having  a  price.  And,  in  the  case  of  the  latter,  it  is 
quite  certain  that,  in  the  long  run,  the  price  of  wheat  must  be  high 
enough  to  include  an  element  representing  the  money  spent  for 
labor  in  producing  that  wheat ;  otherwise,  plainly,  the  farmer  could 
not  afford  to  pay  for  such  labor.  Nevertheless,  the  fact  that,  in  the 
long  run,  there  must  be  in  the  value  of  the  product  an  element  cor- 
responding to  the  contribution  made  by  each  factor  does  not  justify  us 
in  describing  that  factor  as  producing  that  value.  The  factor  pro- 
duces its  special  type  of  utility;  the  totality  of  economic  conditions 
brings  into  existence  the  corresponding  increment  of  value. 

Impute  to  Each  His  Immediate  Product. — Another  very  im- 
portant point  to  be  remarked  under  this  head  is  that  we  should 
attribute  to  each  producer  the  particular  commodity  (or  the  par- 
ticular service)  for  which  he  is  immediately  responsible.  Thus,  the 
farmer  produces,  not  bread  nor  flour,  but  wheat.  The  miller 'produces 
not  bread  but  flour.  The  employees  of  the  miller  produce  not  flour 
but  services,  which  the  miller  combines  with  the  services  of  various 
machines  and  wheat  in  such  a  way  that  he  produces  flour. 

Other  Meanings. — The  above  discussion  has  brought  out  that 
meaning  of  production  which  is  generally  looked  on  by  present-day 
economists  as  the  most  useful  one.  But,  as  remarked  at  the  outset, 
we  occasionally  use  the  term  in  other  senses,  especially  narrower 
ones,  and  we  shall  probably  continue  to  do  so.  Thus,  it  is  sometimes 
convenient  to  follow  the  popular  usage  which  cuts  off  one  class  of 
producers  from  the  rest,  representing  them  as  mediators  between 
producers  and  consumers.  I  have  in  mind,  of  course,  the  exchanging 
class,  who  occupy  a  unique  place  in  the  system,  in  that  they  appear  at 
every  stage  in  the  long  chain  of  processes  leading  from  the  first-stage 
producers  to  the  ultimate  consumer,  mediating  between  each  member 
of  the  technical  part  of  the  series  and  his  next  neighbor.  Thus  they 


IV]  ANALYSIS  OF  PRODUCTION  51 

act  as  go-betweens  between  the  stock-raisers  and  the  tanners;  be- 
tween the  tanners  and  the  shoemakers ;  between  the  shoemakers  and 
the  shoe  wearers.  Accordingly,  we  often  find  it  convenient  to  use 
expressions  like  this :  "It  is  the  function  of  the  exchanging  class 
to  correlate  producers  and  consumers."  That  is,  we  sometimes  use 
the  term  producers  to  include  all  sorts  of  contributors  to  the  pro- 
duction of  commodities  and  services  except  the  exchanging  class. 
No  harm  need  result  from  this,  if  we  remember  that,  in  the  deeper, 
larger  sense,  all  who  contribute  in  any  kind  or  degree  to  the  existence 
of  utilities  are  producers. 

As  a  last  comment  under  our  present  head,  we  add  a  word  with 
respect  to  the  scope  of  the  economist's  study  of  this  topic,  production. 
For  it  hardly  need  be  said  that  the  study  of  production  undertaken  by 
the  economist  is  by  no  means  exhaustive.  Much  the  larger  part  of 
what  might  seem  to  belong  under  this  head  is  commonly  relegated  to 
technical  sciences  or  arts  such  as  Engineering,  Agriculture,  and  Me- 
chanics. Economics  proper,  especially  the  Principles  of  Economics, 
is  primarily  concerned  with  that  particular  aspect  of  goods  which,  as 
we  noted  in  the  first  chapter,  makes  them  economic,  that  is,  value, 
though  it  is  not  entirely  confined  to  this  topic.  When  dealing  with 
the  physical,  technical,  side  of  economic  goods — and  production  is 
mostly  concerned  with  this  side — we  limit  our  study  to  certain  most 
general  aspects  of  the  matter. 


ILLUSTRATIVE  PROBLEMS 

1.  The  conception  of  "produce"  held  by  the  man  who  calls  middle- 
men parasites  is  really  the  same  as  the  one  given  in  the  text,  though  we 
emphatically  deny  his  contention  that  middlemen  are  parasites.     Defend 
that  statement. 

2.  "St.  Thomas  is  not  a  producing  island.     Its  importance  consists 
in  its  position  as  a  harbor  of  refuge  and  a  coaling  station,  and  as  a  place 
for  refitting  vessels."     Show  from  the  passage  that  St.  Thomas  is  a  pro- 
ducing island,  as  we  understand  the  word. 

3.  Have  the  playing  cards  of  a  gambler  utility?     Are  they  wealth? 
Has  a  diamond  ring  utility? 


52  PRINCIPLES  OF  ECONOMICS  [IV 

4.  A  man  who  is  getting  no  income  now  but  expects  to  have  one 
six  months  from  now  borrows  $100  from  his  neighbor,  promising  to  pay 
back  the  $100  and  $6  more  at  the  end  of  a  year. 

(a)  Does  the  $6  represent  any  advantage — service — received  by  the 
borrower  ? 

(b)  If  so,  can  the  lender  reasonably  be  credited  with  the  production 
of  that  service? 

5.  "Only  miners,  lumbermen,  farmers,  and  such  like  ought  to  be 
called  producers;  for  they  are  the  only  ones  who  add  something  to  the 
total  wealth.     The  rest  merely  change  the  form  or  relations  of  the  things 
which  the  above-named  produce." 

Show  that  there  is  no  essential  difference  in  the  contributions  of  the 
farmer,  the  miller,  the  baker,  the  grocer,  and  the  delivery  man. 

6.  "The  Chinaman  lives  economically.     He  earns  all  he  possibly  can 
and  saves  it  and  takes  it  back  to  his  native  land.     He  is  a  very  econom- 
ical consumer,  and  instead  of  being  a  wealth  producer,  acts  as  a  leech 
upon  the  wealth  of  the  nation,  sucking  in  all  that  he  can  and  taking  it 
away  to  enrich  the  land  of  his  ancestors."    Criticize  the  part  in  italics. 

7.  Mr.  X  hires  the  opera  house  for  an  evening  and  hires  the  Men- 
delssohn Quartette  to  give  a  concert  in  it.     I  pay  75  cents  to  hear  the 
concert. 

(a)  In  precisely  what  does  the  wealth  which  I  buy  consist,  the  work 
of  the  singers,  the  pleasure  I  derive  from  the  singing,  or  something  else  ? 

(b)  Did  the  Quartette  produce  the  wealth  I  bought,  or  something 
else? 

(c)  If  the  Quartette  did  not,  who  did? 

8.  "Thus  there  are  today  tens  of  thousands  of  lawyers,  bankers, 
traders,  middlemen,  speculators,  and  others,  whose  functions,  necessary 
to  the  capitalistic  regime,  would   (under  socialism)   cease  to  have  any 
value.     They  would  be  compelled  because  of  this  to  enter  the  producing 
class." 

(a)  Show  from  the  quotation  itself  that,  under  a  reasonable  inter- 
pretation of  the  phrase  "producing  class,"  the  groups  of  persons  named 
are  already  in  that  class. 

(b)  May  the  labors  of  these  persons  be  productive  now,  although 
they  would  not  be  productive  under  socialism?    Don't  forget  to  explain. 

9.  "Labor  alone  is  the  producer  of  wealth ;  take  away  labor  and  not 
all  the  capital  in  the  world  could  produce  anything." 


IV]  ANALYSIS  OF  PRODUCTION  53 

Allowing  the  second  clause  to  be  true  as  a  statement  of  fact,  does  it 
prove  the  proposition  contained  in  the  first? 

10.  Accepting  the  conception  of  wealth  given  in  this  text,  the  con- 
ductor of  a  street  car  is  a  producer  of  wealth. 

(a)  Just  what  form  of  wealth  does  he  produce? 

(b)  For  whom  does  he  produce  it? 

(c)  Who  produces  the  wealth  I  buy  when  I  ride  in  the  cars? 

II 
Economic  Factors  of  Production 

Factors  in  General. — It  is  obvious  on  the  least  reflection  that 
to  produce  wealth  or  economic  goods  necessitates  the  combined  opera- 
tion of  different  things, — different  elements,  forces,  conditions.  To 
raise  potatoes,  for  example,  we  need  a  place  on  the  land,  suitable  soil, 
labor,  tools,  sunlight,  moisture,  nitrogen  from  the  air,  and  so  on. 
Now,  all  these  different  things — these  elements,  forces,  conditions, — 
we  call  factors  of  production.  They  include  everything  which  con- 
tributes to  the  result  attained;  and  their  number  is  legion.  For 
purposes  of  distinction,  we  usually  refer  to  them  as  physical  or 
technical  factors.  But  not  all  of  these  factors  belong  to  our  study. 
A  very  considerable  number  of  them  we  call  non-economic,  meaning 
that  they  are  lacking  in  the  characteristics  which  belong  to  all  things 
economic.  While  all  of  them  are  useful,  not  to  say  necessary,  to 
man,  they  are  not  appropriable,  or  are  superabundant,  or  are  given 
gratuitously  by  the  government,  or  for  some  other  reason  fail  to 
take  on  the  property  of  value,  especially  pecuniary  value,  which  is 
the  distinguishing  mark  of  economic  things.  Non-economic  factors 
include  the  sunlight,  moisture,  and  nitrogen,  mentioned  above,  also 
the  body  of  knowledge  inherited  from  the  past  by  each  generation, 
the  protection  of  government  necessary  to  successful  production,  the 
many  direct  contributions  of  government  to  productive  processes,  the 
gratuitous  advice  and  assistance  of  other  persons  not  directly  par- 
ticipating in  a  particular  task,  and  many  other  things  one  could  men- 
tion. Many  of  these  non-economic  factors  are  absolutely  essential 
and  so  of  a  generic  importance  indefinitely  great.  But,  in  general,  the 
economist  gives  them  brief  consideration  because  they  do  not  belong 


54  PRINCIPLES  OF  ECONOMICS  [IV 

to  his  realm  or  belong  to  it  only  in  a  very  limited  sense.  His  study, 
therefore,  is  chiefly  occupied  with  those  factors  of  production  which 
are  strictly  economic. 

Economic  Factors. — The  distinguishing  characteristic  of 
economic  factors  was  noted  above.  Such  factors  have  value, — in  the 
present  order,  have  exchange  value,  and  that  expressed  in  terms  of 
money — pecuniary  value.2  These  economic  factors  are  very  numer- 
ous, including  the  land,  the  great  variety  of  substances  out  of  which 
or  with  the  help  of  which  man  produces  goods,  and  many  different 
types  of  effort  or  sacrifice  which  man  himself  must  undergo.  In 
some  important  economic  problems,  we  may  as  well  at  the  outset 
recognize  that  the  differences  among  factors  are  largely  irreducible — 
that  nothing  is  gained  by  treating  them  together.  But,  in  many  other 
connections,  it  is  convenient,  almost  necessary,  to  group  these  factors 
into  a  few  large  classes.  One  of  the  most  common  methods  of  doing 
this  recognizes  three  such  classes :  ( i )  materials,  services,  and  instru- 
ments, coming  from  nature,  for  example,  iron  ore,  standing  room  on 
the  earth's  surface,  water  power;  (2)  labor  services  supplied  by 
man  himself;  and  (3)  materials  and  services  from  instruments  which 
have  been  produced  to  be  used  in  further  production,  e.g.,  pig  iron, 
the  services  given  off  by  an  engine.  The  various  factors  of  the  first 
group  are  usually  designated  by  the  one  term  land;  those  of  the  sec- 
ond by  the  word  labor;  and  those  of  the  third  by  the  word  capital. 
We  will  now  make  some  more  specific  comments  on  each  of  these 
three  types  of  factors. 

Land. — That  land  in  the  broad  sense  above  noted  is  necessary 
to  the  producing  of  goods  is  too  evident  to  need  serious  argument. 
Obviously  nothing  can  be  produced  without  having  in  it  stuff,  ma- 
terial ;  and,  since  man  cannot  create  substance,  such  stuff  or  material 
must  come  from  nature.  Things  of  this  sort  constitute  the  primary 
raw  materials.  Again,  it  is  plain  that  we  can  do  nothing  without  a 


*A  particular  factor  might  be  an  economic  factor  under  the  present  order 
though  it  might  be  merely  a  technical  factor  under  some  other  order.  A 
shortage  of  supply  is  necessary  to  make  anything  an  economic  factor,  and 
this  may  be  produced  artificially  where  the  naturally  abundant  supply  is 
under  a  single  control. 


IV]  ANALYSIS  OF  PRODUCTION  55 

place  on  which  to  work,  locate  buildings,  machinery,  etc.  Still,  again, 
the  simplest  agricultural  operations  require  the  activity  of  the  biologi- 
cal forces;  while  getting  needed  power  requires  the  assistance  of  the 
expansive  force  of  gases  or  the  power  of  moving  air  or  falling  water. 

But,  though  these  various  elements  of  natural  origin  are  so  mani- 
festly factors  in  production,  not-  all  which  serve  in  this  capacity  are 
true  economic  factors.  Thus,  air,  moisture,  and  sunlight,  while  neces- 
sary to  production  as  physical  or  technical  factors,  are  not  controllable 
or  appropriable,  and  therefore  lack  the  element  of  value, — for  which 
reason,  they  have  no  standing  as  economic  factors.  Again,  position 
on  the  earth's  surface,  though  appropriable,  may  fail  of  being  counted 
as  a  true  economic  factor.  In  partially  settled  countries  some  of  the 
land  actually  in  use  is  no  more  desirable  than  much  which  is  not  in 
use;  there  are  other  waste  pieces  lying  all  about  which  could  be 
substituted  for  the  used  piece  with  no  decrease  in  the  product,  and 
at  practically  no  expense.  Now,  because  other  land  of  its  kind  is 
so  abundant,  the  particular  piece  first  occupied  will  have  no  price. 
It  will  be  a  free  good,  like  air  or  moisture,  and  so,  according  to  our 
definition  of  "economic,"  will  not  be  an  economic  factor. 

But,  after  all,  comparatively  few  of  nature's  contributions  can 
be  disposed  of  in  this  way.  While  position  on  the  earth  is  free  in  the 
wilderness,  it  is  in  settled  communities  very  distinctly  not  free,  be- 
cause, in  proportion  to  the  population,  it  has  become  scarce.  Com- 
monly, then,  land,  as  position,  on  the  earth's  surface, — the  original, 
unproducible,  indestructible  earth — is  a  true  economic  factor.  No 
argument  is  needed  to  show  that  the  same  is  often  true  of  Primary 
Raw  Materials,  such  as  coal  and  iron  in  the  earth  and  standing  timber 
in  the  forest ;  these  also  usually  have  value  because  relatively  scarce, 
and  so  must  be  accounted. 

Some  might,  perhaps,  object  to  the  argument  that  land  necessarily 
comes  to  have  value  and  so  comes  to  be  an  economic  factor,  in  this 
wise.  "All  land  was  originally  a  free  good,  a  gift  of  nature.  That  it 
now  has  value  and,  so,  is  an  economic  factor  in  the  sense  here  used, 
is  due  to  unjust  laws  which  authorize  private  persons  to  own  it, — 
make  it  their  property."  The  unsoundness  of  this  view  is  easily 
shown.  Ownership  is  essential  to  the  existence  of  exchange  value; 
but  such  value  cannot  be  given  by  ownership  alone;  there  must  be 


56  PRINCIPLES  OF  ECONOMICS  [IV 

scarcity  as  well.  If  there  is  monopolistic  ownership,  to  be  sure,  this 
scarcity  itself  may  be  secured  artificially,  and  so  the  economic  char- 
acter which  the  scarcity  helps  give  to  the  land  will  be  in  so  far 
arbitrary  in  nature.  But  the  ownership  of  land  is  not  usually  monopo- 
listic ;  there  are  many  competing  owners.  It  follows  that  the  scarcity 
necessary  to  give  land  value — make  it  an  economic  factor — cannot  be 
due  to  the  fact  that  that  land  has  become  subject  to  ownership.  Such 
scarcity,  broadly  speaking,  is  a  natural  condition,  a  condition  arising, 
not  from  a  policy  which  man  deliberately  adopts,  but  because  the 
quantity  and  capacity  of  the  elements  furnished  by  nature  are  defi- 
nitely limited  and  prove  to  be  inadequate  to  satisfy  all  man's  needs. 
Even  under  socialism,  land  would  have  a  natural  value  because  of  its 
natural  scarcity,  and  for  that  reason  would  be  an  economic  factor, 
just  as  truly  as  now ;  only,  the  owner  of  the  land  would  then  be  the 
state,  and  accordingly  the  contribution  made  by  the  land  in  production 
would  be  credited  to  the  state  rather  than,  as  now,  to  private  indi- 
viduals. We  must  conclude,  therefore,  that,  wherever  land  is  scarce 
relatively  to  need,  it  should  be  counted  as  one  of  the  true  economic 
factors  of  production. 

Labor. — Under  this  head  we  include  all  services  contributing 
to  the  existence  of  commodities  which  have  their  origin  in  human 
effort.  This  should  be  understood  as  meaning  not  only  labor  in  the 
popular  sense  of  physical  exertion,  but  also  mental  and  nervous 
efforts  of  any  sort — bookkeeping,  managing,  advertising,  or  pro- 
moting. It  makes  no  difference  how  humble  the  effort  or  how  high, 
it  makes  no  difference  whether  the  effort  be  directly  applied  to  the 
materials  out  of  which  the  good  is  being  produced,  or  whether  it 
be  applied  indirectly,  as  in  the  management  of  a  concern  or  in  service 
on  the  board  of  directors — that  effort  classifies  in  the  economic  sense 
as  labor. 

That  the  functions  thus  performed  by  labor  are  essential  to  almost 
every  kind  of  production,  is  too  evident  to  need  argument.  Labor  is, 
therefore,  a  factor  in  production, — a  physical  or  technical  factor.  But 
it  is  no  less  certain  that  labor  is  also  a  true  economic  factor.  It  can- 
not be  had  for  the  asking ;  it  is  scarce  relatively  to  the  need  for  it ;  it 
has  exchange  value. 


IV]  ANALYSIS  OF  PRODUCTION  57 

Capital. — As  indicated  on  page  54,  capital  is  commonly  defined 
by  economists  as  being  produced  goods  used  to  assist  in  further 
production.  That  such  goods  play  a  very  important  part  in  the 
productive  process  is  surely  evident.  Almost  all  industries  except  the 
most  primary  ones  work  upon  materials  which  have  been  produced 
as  distinguished  from  the  primary  raw  materials  mentioned  on  page 
55.  Again,  almost  every  worker  must  have  tools,  instruments,  which 
have  to  be  produced.  Still,  again,  we  could  accomplish  but  a  tithe 
of  what  we  now  accomplish  save  for  the  help  of  great  natural  powers 
such  as  falling  water;  and  these  can  be  made  available  only  by  the 
help  of  elaborate  constructions  such  as  dams  and  water  wheels.  In 
turn,  these  powers  can  be  utilised  only  through  great  machines  which 
have  to  be  produced. 

Again,  capital,  conceived  in  the  way  above  indicated,  that  is,  as 
consisting  of  a  body  of  intermediate  products,  products  devoted  to 
producing  other  products,  is  not  only  an  important  factor  in  the 
productive  process — it  is  also  an  economic  factor.  Such  intermediate 
goods,  machines,  tools,  materials,  cannot  be  had  gratuitously.  We 
must  pay  for  them,  just  as  we  have  to  pay  for  labor  or  for  the  use 
of  land. 

This,  however,  is  not  the  end  of  the  matter.  Capital,  as  thus  con- 
ceived, is  of  course  a  factor  in  production  and  an  economic  factor. 
But,  then,  capital  as  thus  conceived  is  nothing  more  than  the  land, 
labor,  and  previous  capital  entering  into  it ;  and,  going  back  to  the 
very  beginning,  it  is  nothing  more  than  the  land  and  labor  entering 
into  it.  In  other  words,  if  this  way  of  conceiving  capital  covers 
everything  contained  in  it,  we  scarcely  ought  to  talk  about  capital  at 
all,  but  only  about  the  capitalistic  method  of  using  land  and  labor. 
Still  further,  the  natural  place  to  make  any  needed  comment  on  this 
special  method  of  production  would  seem  to  be  under  the  factors 
really  involved,  namely :  land  and  labor. 

We  naturally  ask,  then,  why  does  not  the  economist  pursue  such 
a  course?  The  answer  is  that  the  economist  believes  that,  in  some 
sense  or  degree,  there  is  to  be  found  in  capital  some  element  other 
than  land  and  labor — that  the  use  of  the  capitalistic  method  involves 
some  condition  which  the  land  owner  as  such  or  the  laborer  as  such 
cannot  fulfil — an  element  which,  therefore,  makes  capital  into  a  factor 


58  PRINCIPLES  OF  ECONOMICS  [IV 

other  than  mere  land  and  labor.  He  further  believes — better,  perhaps, 
knows — that  this  element,  as  well  as  land  and  labor,  has  its  price,  and, 
therefore,  is  not  only  a  factor,  but  also  an  economic  factor.  On  the 
basis  of  the  belief  just  indicated,  he  naturally  sets  about  trying  to 
find  out  just  what  it  is  that  constitutes  this  distinctive  element  in 
capital,  how  it  is  brought  into  existence,  what  function  it  performs, 
and  so  on.  The  following  chapter  will  be  devoted  to  an  attempt  to 
cover  in  some  measure  these  problems. 


CHAPTER  V 

CAPITAL  AS  CAPITAL 

The  close  of  the  last  chapter  brought  us  to  the  point  of  conceiving 
capital  as  having  in  it  some  element  additional  to  the  land  and 
labor  which  produced  it,  and  therefore  as,  in  some  sense  or  degree, 
constituting  a  factor  different  from  such  land  and  labor.  As  such  a 
different  factor,  it  surely  calls  for  a  special  treatment.  We  now  un- 
dertake this  task ;  and  since  it  is  one  of  the  most  difficult  in  economic 
science,  we  shall  have  to  ask  for  more  than  ordinary  care  and  patience 
on  the  student's  part. 

I 
Capital  as  Carrying-Power,  Waiting-Power 

How  the  Problem  Arises. — We  will  begin  by  setting  before 
ourselves  the  general  group  of  phenomena  associated  not  only  with 
production  but  also  with  our  whole  economic  life,  which  are  chiefly 
responsible  for  the  existence  of  our  present  problem.  Let  us  suppose 
that,  because  of  some  unparelleled  catastrophe,  the  total  population 
of  a  given  modern  community  is  instantly  taken  out  of  life,  though 
everything  else  remains  as  before.  Let  us  suppose,  further,  that  an 
observant  and  intelligent  visitor  at  the  scene  of  destruction  makes  a 
rough  inventory  of  all  forms  of  products — produced  wealth — to  be 
found  in  the  place.  Doubtless  as  a  result  of  his  efforts  there  would 
present  themselves  a  number  of  interesting  and  important  groupings 
of  these  products ;  but  only  one  of  these  is  especially  significant  for 
our  present  purposes.  That  one  divides  all  the  economic  products 
into  two  groups  as  follows:  (i)  a  small  body  of  products  and 
services  of  products  1  which,  if  the  great  catastrophe  had  not  come, 
would  have  been  devoted  to  the  satisfying  of  immediate  wants,  and 
(2)  a  great  body  of  products  and  services  of  products  which  would 


1  To  be  explained  in  a  moment. 

59 


6o 


PRINCIPLES  OF  ECONOMICS 


[V 


not,  and,  generally  speaking,  could  not,  have  been  put  to  such  im- 
mediate use,  but  would,  instead,  have  been  kept  in  reserve  for  the 
satisfying  of  future  wants.  These  two  groups  we  may  perhaps 
advantageously  designate  as  active  goods  and  reserve  goods,  or  im- 
i  mediate-service  goods  and  future-service  goods. 
They  may  also  be  distinguished  as  active  goods 
and  idle  goods,  though  the  latter  designation  is 
liable  to  cause  misunderstanding. 

This  distribution  of  the  whole  body  of 
products  and  services  of  products  belonging  to 
our  imaginary  community,  into  active  goods  and 
reserve  goods,  is  brought  out  in  the  accompanying 
diagram,  Figure  i.  The  lower,  heavily-shaded 
portion  of  the  rectangle  represents  the  active 
goods  of  the  community ;  the  upper  lightly-shaded 
portion  represents  the  idle  or  reserve  goods. 
The  marked  difference  in  the  size  of  the  two 
portions  brings  out  the  point  that  our  supposed 
visitor  would  find  the  active  goods,  immediate- 
service  goods,  constituting  but  a  very  small  share 
of  the  total. 


Figure  i.    Active 
and  Reserve  Goods 


Reserve  Goods  Indispensable. — The  above 
account  of  the  probable  conditions  of  things  in 
our  hypothetical  community  has  obviously  im- 
plied that  such  a  condition  is  not  at  all  abnormal, 
is  in  fact  just  the  natural,  usual  condition.  Such 
a  relation  between  the  quantities  of  idle  and  active  goods  as  that 
indicated  is  bound  to  prevail  in  any  community  with  a  highly  de- 
veloped industrial  system.  High  efficiency  requires  that  we  spend 
a  large  share  of  our  productive  resources  in  maintaining  a  stock 
of  the  goods  which  are  not  to  be  used  in  the  satisfying  of  immediate 
wants.  Let  us  note  some  of  the  more  important  reasons  why 
this  is  true. 


Contingent  Reserves. — Perhaps  the  case  which  displays  this 
necessity  in  the  purest  form,  with  the  least  admixture  of  other  ele- 


V]  CAPITAL  AS  CAPITAL  6l 

ments,  is  to  be  found  in  what  we  may  call  contingent  reserves,  by 
which  we  mean  reserves  which  are  held  to  meet  needs  which  cannot 
be  precisely  anticipated,  needs  which  are  more  or  less  unexpected, 
contingent.  Manifestly  such  reser.ves  are  practically  indispensable 
in  the  case  of  many  consumption  goods.  No  one  above  the  pauper 
class  would  think  of  trying  to  get  along  with  only  one  collar  or  only 
one  shirt  or  only  one  pair  of  socks,  making  it  necessary  to  go  without 
any  while  the  one  was  being  laundered.  In  like  manner,  we  always 
have  in  the  house  more  food  than  will  be  wanted  for  the  next  meal ; 
more  fuel  than  will  be  wanted  during  the  one  day ;  and  so  on.  And 
one  reason  why  this  is  necessary  is  suggested  by  the  word  "con- 
tingent"— such  reserves  are  needed  to  meet  situations  which  may 
arise  unexpectedly,  situations  which,  because  they  were  unexpected, 
could  not,  without  reserves,  be  provided  for  at  all  or  only  at  much 
inconvenience.2 

But  contingent  reserves  are  needed  not  only  in  consumption  but 
also,  and  on  a  far  larger  scale,  in  production.  The  factory  devoted 
to  making  shoes  needs  to  keep  stocks  of  leather,  nails,  thread,  parts 
of  machinery,  shipping  cases,  etc.,  considerably  in  excess  of  pre- 
cisely ascertainable  needs.  Further,  this  does  not  merely  apply 
to  the  things  used  in  the  productive  process ;  the  factory  must  also 
keep  contingent  reserves  of  the  product  itself — its  own  product.  It 
could  not  afford  to  be  content  with  a  stock  just  sufficient  to  meet  the 
demands  of  the  moment,  since  these  could  not  be  calculated  in  ad- 
vance. Nor  could  it  be  content  with  a  stock  just  equal  to  the  average 
demand,  since  there  would  be  variations  above  this  average  as  well 
as  below.  This  is  still  more  conspicuously  true  for  the  shop  which 
deals  in  the  shoes  of  our  factory,  since  the  dealer  has  not  the  power 
possessed  by  the  manufacturer,  through  his  control  of  plant,  ma- 
chinery, and  labor,  of  speeding  up  the  process  by  which  shoes  are 
turned  out. 

This  case  of  contingent  reserves  is  graphically  presented  in  Figure 
2.  The  shaded  rectangle  at  the  left  represents  the  amount  of  a  par- 
ticular product  which  the  manager  considers  necessary  to  provide  for 


*  Doubtless  there  are  other  reasons  for  keeping  such  reserves  beside  this 
contingent  element;  but  contingent  reserves  give  us  a  case  which  is  theo- 
retically of  much  importance. 


62 


PRINCIPLES  OF  ECONOMICS 


[V 


the  possible  needs  of  the  period  of  stocking-up  customary  in  his  line,— 
a  week  or  a  month  or  whatever  it  may  be.  The  portion  of  this  total 
which  in  all  probability  will  actually  be  used  during  that  period  is 
represented  by  the  larger  of  the  two  sections  into  which  this  rectangle 
is  divided  by  the  horizontal  line.  In  the  first  compartment  of  the 
enclosed  space,  we  have  the  state  of  things  at  the  end  of  the  first 
period.  The  larger  portion  of  the  stock  has  been  utilized,  as  is  shown 
by  its  appearing  heavily  shaded  in  the  space  between  the  two  hori- 


1924 


1925 


1926 


192 


Figure  2.     Contingent  Reserves 

zontal  lines  below.  But,  even  when  this  has  been  done,  a  portion  still 
remains  in  the  lightly  shaded  rectangle  above.  This,  of  course,  is  the 
reserve.  In  the  second  compartment,  the  management  is  represented 
as  renewing  the  stock  to  its  first  level  by  purchase  outside  or  by 
production  within  (the  bent  arrow  from  above  indicating  this  opera- 
tion). As  before,  the  productive  processes  of  this  period  use  up 
what  is  needed  (indicated  by  the  appearance  below  of  the  heavily 
shaded  square)  ;  and,  as  before,  a  surplus  or  reserve  substantially  the 
same  in  amount  as  the  preceding  remains  intact.  And,  obviously,  this 
course  of  things  must  go  on  indefinitely. 


V]  CAPITAL  AS  CAPITAL  63 

The  Periodicity  of  Nature. — We  have  noted  the  particular 
reason  for  the  maintenance  of  stocks  of  idle  goods,  reserves,  which 
grows  out  of  our  inability  to  anticipate  our  needs  with  absolute  pre- 
cision,— a  fact  which  leads  us  to  designate  reserves  of  this  type 
contingent  reserves.  But  there  are  many  other  conditions  making 
the  maintenance  of  reserves  in  one  sense  or  another  very  necessary. 
Notable  among  these  is  the  periodicity  of  nature  in  respect  to  her 
productive  processes.  Thus  practically  all  kinds  of  crops  mature 
only  at  certain  seasons  of  the  year.  This  compels  us,  in  the  case  of 
almost  any  farm  product,  to  provide  for  the  total  needs  of  any 
year  during  a  few  weeks  or  months  of  that  year ;  and  this  in  turn 
means  that  during  much  of  the  year  we  must  be  maintaining  reserve 
stocks  of  such  products  far  in  excess  of  immediate  needs. 

Installment-Service  Goods. — A  much  more  important  reason 
why  we  have  to  maintain  reserves  of  goods  or  their  services  than 
any  yet  mentioned  is  to  be  found  in  the  fact  that  efficiency  in  produc- 
tion requires  us  to  make  use  of  many  produced  goods,  tools,  machines, 
buildings,  etc.,  which  give  off  their  services  only  in  stages,  little  by 
little — installment-service  goods  we  may  call  them.  Thus  take  the 
case  of  a  farm  tractor  which,  for  the  sake  of  simplicity,  we  will  sup- 
pose to  last  in  full  efficiency  for  a  period  of  five  years  and  then  all 
at  once  become  useless.  Such  a  machine  must  be  thought  of  as  a 
bundle  of  services  measured  most  naturally  in  some  time  unit,  say  a 
year  or  a  quarter  or  a  month.  By  having  control  of  the  tractor  for 
any  such  interval,  we  are  able  to  accomplish  much  work  of  various 
sorts.  The  first  quarter  it  gives  off  one  installment  of  possible 
service,  the  second  quarter  another  installment,  the  third  another,  and 
so  on;  and  manifestly  we  could  get  the  benefit  of  these  services  only 
as  they  were  given  off.  That  is,  during  the  first  quarter  we  could 
utilize  but  ONE.  service.  But,  now,  though  we  could  enjoy  only  one 
service  during  this  quarter,  we  should  have  to  have  on  hand  the  whole 
outfit  of  such  services  tied  up  in  a  tractor  lasting  five  years,  that  is, 
twenty  in  all ;  for  such  a  tractor  can  be  made  only  as  a  whole.  It 
follows  that  during  the  three  months  which  pass  while  we  are  getting 
the  first  installment  of  the  tractor's  services,  we  should  Ji^je  to  keep 
in  idleness  the  remaining  nineteen;  while  we  were  utilizing  the  second 


64 


PRINCIPLES  OF  ECONOMICS 


[V 


1924 

1925 

1     1     1 

1     1     1 

installment,  we  should  have  to  keep  in  idleness  the  remaining  eight- 
een ;  and  so  on.  This  is  brought  out  in  Figure  3.  The  tractor  ready 
for  use  at  the  end  of  1923  is  represented  by  the  vertical  rectangle 
at  the  extreme  left;  the  divisions  of  this  rectangle  made  by 

the  incomplete  partitions  represent  the 
twenty  installments  of  three-months 
services  which  the  tractor  is  supposed  to 
give  off  during  its  lifetime.  In  the  first 
quarter  of  1924,  the  first  installment  is 
used  up,  as  is  shown  by  its  transfer  to 
the  space  between  the  horizontal  lines 
below,  while  the  nineteen  unused  install- 
ments remain  above,  showing  that, 
though  unused,  they  have  to  be  "car- 
ried." In  the  second  quarter,  the  second 
installment  is  used  up  and  so  passes  into 
the  space  below,  leaving  eighteen  idle 
installments  to  be  carried.  And  so  on. 

But  it  is  hardly  necessary  to  say  that 
the  life  history  of  a  single  tractor  does 
not  fully  cover  the  situation.  By  hypoth- 
esis, our  tractor  lasts  but  five  years, 
and  therefore  must  be  replaced  if  this 

f 

system  of  production  is  to  go  on.  Con- 
sequently, while  the  twenty  services 
bound  up  in  the  first  tractor,  are  being 
utilized,  we  must  be  making  another 

bundle  of  tractor  services,  that  is,  another  tractor,  to  take  the  place  of 
the  first  when  the  twentieth  service  is  used  up.  It  follows  that  the 
employment  of  this  method  of  production  requires  the  continuous 
maintenance  of  a  fund  of  twenty  idle  services  of  tractors  partly 
derived  from  the  old  tractor,  partly  from  the  new.8  This  is  brought 
out  in  Figure  4.  In  this  we  have  side  by  side  eight  columns,  each 

*  Understood  literally,  this  of  course  applies  only  to  the  community  taken 
as  a  whole.  The  farmer  does  not  set  about  making  another  tractor  little  by 
little,  but  accumulates  during  the  lifetime  of  the  first  tractor  the  sum  of 
money  necessary  to  buy  a  second  one  made  by  some  one  else. 


Figure  3.-    Installment 
Service  Goods  A 


CAPITAL  AS  CAPITAL 


containing  twenty  divisions  representing  twenty  different  tractor 
services  of  three  months  each.  The  first  contains  nineteen  belonging 
to  the  original  tractor — lightly  shaded — and  one  belonging  to  the  new ; 
the  second  column  shows  eighteen  services 
of  the  old  and  two  of  the  new;  the  third, 
seventeen  of  the  old  and  three  of  the  new; 
and  so  on. 


1924 

1925 

1     1     1 

1     I     1 

Many-Stage  Goods. — The  last  reason 
we  shall  mention  why  efficiency  in  pro- 
duction requires  that  we  should  maintain 
a  large  stock  of  reserve  goods  is  to  be 
found  in  the  fact  that  the  materials  out  of 
which  many  commodities  are  made,  those 
intermediate  products  which  eventually 
emerge  as  final  products,  have  to  pass 
through  several  or  many  different  pre- 
liminary stages,  and,  while  actually  in  any 
one  of  these,  cannot  be  utilized  in  the 
satisfying  of  wants — while  passing  through 
these  stages,  they  are  merely  to-be  goods, 
inchoate  goods,  goods  in  the  making.  Thus 
the  shoes  which  I  wear  must  have  been 
first  skin  on  the  body  of  some  animal,  then 
hide  in  process  of  tanning,  then  leather  at 
the  shoe  factory,  then  finally  shoes.  Up 

to  the  last  stage,  they  plainly  must  have  been  reserve  goods — idle 
goods,  from  the  standpoint  of  the  satisfying  of  immediate  wants. 

This  point  is  illustrated  in  Figure  5.  The  product  chosen  is 
some  rapidly  growing  tree,  say  a  catalpa,  which  matures  sufficiently 
for  making  fence  posts  in,  let  us  say,  five  years.  The  square  in  the 
upper  left  corner  represents  a  plantation  of  these  trees  started  at  the 
beginning  of  1924;  at  the  beginning  of  1925  we  move  it  down  into 
the  second  compartment,  indicating  that  it  has  advanced  a  one-year 
stage  toward  the  status  of  a  matured  product;  the  beginning  of 
1926  finds  it  in  the  third  stage;  and  by  1929  it  is  ready  for  utiliza- 
tion. Obviously,  this  productive  procedure  necessitates  maintain- 


Figure  4.    Installment 
Service  Goods  B 


66 


PRINCIPLES  OF  ECONOMICS 


[V 


ing  every  year  a  fund  of  idle  wealth  represented  by  one  of  the 
squares. 

But  here,  again,  our  statement  is  quite  incomplete.  If  this  sys- 
tem of  production  is  to  go  on  continuously,  we  must  have,  in  addi- 
tion to  the  plantation  of  catalpas  started  in  1924  to  provide  product 


'24 


'25 


'26 


'27 


'28 


'29 


Figure  5.    Inchoate  Goods  A 

for  1929,  a  second  plantation  started  in  1925  to  supply  product  for 
1930,  a  third  started  in  1926  to  supply  product  for  1931,  and  so  on. 
That  is,  once  the  system  is  fully  established,  we  must  maintain  each 
year,  not  one,  but  five  plantations,  one  in  each  stage  of  growth.  This 
is  illustrated  in  Figure  6.  The  plantations  of  every  other  year  are 
shaded  more  lightly  than  the  intermediate  ones  to  make  them  easily 
distinguishable;  but  the  total  after  1928  is  in  each  case  five  planta- 
tions. 

The  preceding  discussion  has  made  it  plain  that  the  condition 
of   things   with   respect   to   products   supposed   to   prevail    in   our 


V] 


CAPITAL  AS  CAPITAL 


67 


imaginary  community  is  absolutely  necessary  to  the  existence  of  any 
highly  efficient  economic  system :  in  addition  to  the  goods  destined 
for  the  satisfying  of  immediate  needs,  we  must  maintain  an  enormous 
fund  of  goods  which,  from  the  standpoint  of  the  present,  are  idle 
goods,  useless  goods,  goods  which  are  not  satisfying  any  wants  of 
ours.  It  is,  indeed,  true  that  each  individual  unit  of  such  goods 
will  sooner  or  later  be  utilized  to  satisfy  wants;  but  by  that  time 
each  must  have  a  substitute  to  replace  it,  so  that  the  fund,  the  total, 


24        '25       '26       '27       '28 


'29   I    '30   I    '31   I    '3 


Figure  6.    Inchoate  Goods  B 

of  such  idle,  useless,  goods  remains  the  same  constantly.  Looked 
at  as  a  fund,  those  goods  are  never  utilized,  are  always  in  reserve, 
always  idle. 

Problems  Involved. — The  explanations  of  the  last  five  or  six 
pages  have  been  primarily  devoted  to  setting  before  the  student 
those  phenomena  involved  in  the  production  of  economic  goods  which 
lead  the  economist  to  add,  to  the  list  of  factors  necessary  to  pro- 
duction, one  which  he  calls  capital.  In  doing  this,  however,  we 
have  more  or  less  anticipated  the  solution  of  the  deeper  problems 
which  these  phenomena  suggest.  Those  problems  are  chiefly:  (i) 


68  PRINCIPLES  OF  ECONOMICS  [V 

Does  the  necessity  for  a  fund  of  reserve  goods  involve  the  recogni- 
tion of  a  new  factor,  a  factor  additional  to  labor  and  land?  (2)  if 
so,  what  is  the  precise  function  of  that  new  factor?  and  (3)  is  the 
factor  thus  isolated  an  economic  factor  as  well  as  a  technical  one? 

Capital  an  Independent  Factor. — The  first  of  these  problems 
is  one  of  great  difficulty,  and  there  is  not  as  yet  general  agreement 
with  respect  to  the  proper  answer.  That  capital  cannot  be  looked 
on  as  wholly  a  new  factor  is  a  proposition  which  would  probably 
gain  general  assent.  Since  the  goods  making  up  the  reserve  fund 
on  which  we  have  laid  such  emphasis  are  products,  they  must  be 
produced,  as  mere  physical  objects,  in  just  the  same  way  as  other 
products,  that  is,  by  the  use  of  all  the  factors  necessary  and  so, 
of  course,  by  labor  and  land,  as  well  as  by  capital,  if  there  is  such 
a  thing.  It  follows  that,  looked  at  in  one  way,  those  goods  are 
merely  embodiments  of  these  antecedent  factors  and,  therefore,  to 
a  considerable  extent  are  merely  "congealed  labor  and  land."  Our 
first  problem,  therefore,  resolves  itself  into  this:  Is  so-called  capital 
only  congealed  labor  and  land?  Put  affirmatively:  Is  there  not  in 
capital,  or  in  the  method  of  production  which  employs  capital,  an 
element  which,  in  some  sense  or  other,  is  different  from,  additional 
to,  labor  and  land?  Probably  most  economists  would  agree  that  the 
correct  answer  to  this  question  in  its  second  form  must  be  an 
affirmative  one, — there  is  an  element  in  capital  different  from,  addi- 
tion to,  labor  and  land;  the  chief  difficulty  is  found  in  determining 
upon  the  best  method  of  establishing  the  point  and  in  ascertaining 
precisely  what  constitutes  this  additional  element. 

Decisive  Proof. — The  consideration  which,  in  the  opinion  of 
the  writer,  furnishes  a  decisive  proof  of  the  contention  that  capital 
or,  anyhow,  the  employment  of  the  capitalistic  method,  involves  an 
element  additional  to  labor  and  land,  is  to  be  found  in  a  fact  of 
business  returns  familiar  to  everyone.  That  fact  is  that  the  returns 
from  any  business  must  be  great  enough  so  that  the  person  re- 
sponsible for  owning,  "carrying,"  the  reserve  goods  necessary  in  that 
business  will  get,  in  addition  to  the  amount  necessary  to  replace 
those  goods  in  so  far  as  they  are  consumed  in  the  productive  process, 


V] 


CAPITAL  AS  CAPITAL 


69 


something  more,  a  surplus,  a  residuum.  To  illustrate,  if  a  firm 
has  $40,000  tied  up  in  the  reserve  goods  of  its  business,  and  puts 
into  its  annual  output  of  product  $30,000  worth  of  goods  and 
services  from  these  reserve  goods,  it  must  get  out  of  the  business, 
not  only  the  $30,000  necessary  to  cover  this  outgo,  but  also  some- 
thing additional,  say  $2,400.*  Now,  since  the  $30,000  is  adequate 


'24 


'25 


'26 


'27 


'28 


'29 


Figure  7.     Return  to  Capital  as  Capital 

to  cover  the  concrete  capital  consumed,  the  $2,400  in  excess  of  that 
sum  must  represent  some  feature,  some  peculiarity,  of  capital  or 
the  capitalistic  method  different  from,  additional  to,  labor  and  land. 
The  point  just  made  is  given  graphic  illustration  in  Figure  7. 
The  diagram  there  appearing  is  the  value  analogue  of  the  illustra- 
tion represented  in  Figure  5.  The  latter  diagram,  it  will  be  recalled, 

*  In  fact,  there  will  need  to  be  a  residuum  greater  than  this  to  cover  the 
contribution  of  still  another  factor,  or  another  contribution  of  this  same 
factor,  capital.  This  will  appear  in  a  moment. 


70  PRINCIPLES  OF  ECONOMICS  [V 

represents  the  development  of  a  catalpa  plantation  which,  only 
after  a  period  of  five  years,  is  sufficiently  matured  to  satisfy  im- 
mediate wants.  But  the  development  there  represented  is  physical. 
The  square,  which  is  found  a  step  further  down  each  year  than  it 
was  the  preceding  year, — the  plantation  having  moved  each  year  a 
stage  nearer  maturity, — represents  this  plantation  merely  as  a  physical 
product.  But  in  actual  life  there  will  be  a  value  development  as 
well.  Even  if  we  suppose  the  plantation  to  need  no  labor  of  any 
kind  after  the  setting  out  of  the  first  year ;  even  if  we  suppose 
that  the  land  used  is  a  free  good,  so  that  no  allowance  has  to  be 
made  in  the  value  of  the  product  for  the  contribution  of.  the  land ; 
nevertheless  five  years  must  elapse  in  order  that  we  may  get  the 
benefit  of  nature's  gratuitous  contribution  to  the  fitness  of  these 
trees  to  satisfy  human  wants.  Because  we  must  keep,  say,  $1,000 
worth  of  wealth  tied  up  in  this  plantation  for  these  five  years,  the 
product  has  to  show,  and  in  actual  life  will  show,  an  increment  of 
value  each  year.  Accordingly,  in  Figure  7,  the  plantation  is  repre- 
sented, after  the  first  year,  not  by  a  series  of  equal  squares,  but  by 
a  series  of  rectangles  increasing  in  area  each  year.  With  each  of 
the  rectangles  the  portion  below  the  horizontal  line  represents  the 
addition  to  value  which,  as  experience  shows,  is  bound  to  come 
with  each  succeeding  year. 

The  fact  that  there  is  such  an  addition  to  value  shows  that  there 
is  something  about  the  capitalistic  method  of  production — some  con- 
dition of  its  employment — which  we  have  not  yet  clearly  isolated. 
For,  in  the  long  run,  the  value  of  products  cannot  be  greater  than 
the  value  of  all  the  elements  entering  into  their  production.5  It 
follows  that,  if  we  find  an  unexplained  element  in  the  value  of 
products,  we  may  be  quite  sure  that  there  is  a  corresponding  factor 
which,  though  not  yet  isolated,  is  necessary  to  the  producing  of  that 
product.  Now  the  increment  of  value  here  considered  is  just  such 
an  unexplained  element.  It  cannot  be  explained  as  corresponding 


'This  does  not  involve  deciding  whether  the  value  of  factors  is  deter- 
mined by  that  of  product  or  vice  versa.  Whatever  be  the  true  course  of 
causation,  there  can  be  no  doubt  that,  generally  speaking,  the  value  of  product 
and  that  of  all  the  factors  must  show  a  close  correspondence;  so  that,  if 
the  value  of  product  is  greater  than  that  of  the  factors  hitherto  enumerated, 
this  must  be  because  some  other  factor  has  been  overlooked. 


V]  CAPITAL  AS  CAPITAL  71 

to  the  labor  element  in  the  product;  for,  by  hypothesis,  there  is  no 
labor  put  in  after  the  first  year  and  this  is  represented  by  the  original 
square  appearing  under  the  year  1924.  Again  this  increment  of 
value  cannot  be  explained  as  corresponding  to  the  contribution  of 
nature  in  developing  the  trees  toward  that  maturity  which  fits  them 
to  satisfy  man's  need ;  for,  by  hypothesis,  nature,  land,  is  in  our 
example  a  free  good,  has  no  economic  character, — no  more  requires 
value  in  the  product  than  does  the  sunshine  or  the  rain.  The  fact, 
then,  that  such  an  increment  of  value  is  bound  to  appear  surely 
shows  that  there  is  something  about  the  capitalistic  method  of  pro- 
duction which  constitutes  a  factor  in  production  different  from, 
additional  to,  labor  and  land. 

Capital  as  Capital. — We  have  seen  that,  though  capital  is 
largely  the  embodiment  of  our  two  original  factors,  labor  and  land, 
there  is  something  connected  with  it,  or  anyhow  with  the  capitalistic 
process  as  a  whole,  which  constitutes  a  factor  in  production  addi- 
tional to  labor  and  land.  But  obviously  this  limits  the  "otherness" 
of  capital  to  some  one  phase  or  aspect  of  that  capital  or  of  the 
capitalistic  process.  In  talking  of  capital  with  only  this  special 
phase  or  aspect  of  the  matter  in  mind,  I  shall  designate  it,  "capital 
as  capital,"  in  contrast  with  what  we  often  call  capital  goods  or 
concrete  capital,  meaning  by  the  latter  the  actual  concrete  products 
which  constitute  that  capital.  But,  having  showed  that  we  must  recog- 
nize the  existence  of  something  about  capital  which  gives  to  it 
independence,  we  have  still  to  answer  the  question:  What  is  that 
something? 

Function  of  Capital  as  Capital. — Perhaps  the  most  natural  way 
to  attempt  the  answer  is  to  ask :  What  is  the  function  involved  in 
capitalistic  methods  which  is  not  performed  by  labor  or  land? 
Understood  in  the  most  immediate  sense,  this  question  has  been 
answered  by  anticipation  in  our  account  of  the  phenomena  char- 
acteristic of  a  capitalistic  economic  order.  If  we  are  to  employ 
the  methods  which  mark  such  an  order,  we  must  maintain  a  great 
volume  of  products  which  are  in  reserve, — which,  from  the  stand- 
point of  the  present,  are  of  no  use  to  us.  But,  manifestly,  the  power 


72  PRINCIPLES  OF  ECONOMICS  (V 

to  do  this  does  not  come  as  a  matter  of  course.  Not  every  person, 
not  even  every  community,  can  do  it.  These  reserve  products  must 
draw  on  our  limited  productive  capacities  just  as  truly  as  do  the 
goods  devoted  to  giving  immediate  service ;  and,  each  for  each,  they 
cannot  be  as  important  as  the  latter,  just  because  they  have  to  do 
with  wants  which  are  only  possible,  as  over  against  wants  which 
are  already  actual.  It  follows  that,  generally  speaking,  we  can 
employ  methods  of  production  which  involve  maintaining  reserves 
only  on  condition  that  we  have  capacities  to  produce  which  can  be 
spared  from  the  service  of  the  present;  which,  in  turn,  requires 
that  we  should,  generally  speaking,  have  accumulated  a  surplus  of 
the  products  which  we  have  been  accustomed  to  look  upon  as  essential 
and  so  can  afford  to  turn  our  capacities  to  the  production  of  reserve 
goods ;  which,  finally,  requires  that  we  should  have  saved,  practiced 
abstinence,  in  order  to  accumulate  such  a  surplus.  Emphasizing  the 
first  and  most  immediate  of  the  three  conditions  named,  we  say: 
The  capitalistic  method  can  be  employed  only  on  condition  that  some 
person  has  been  brought  into  a  position  which  enables  him  to  own, 
"carry"  the  reserve  products  constituting  the  concrete  capital  of  the 
community.  We  may  affirm,  therefore,  that  the  distinctive  function 
of  capital  as  capital  is  to  own  or  carry  the  concrete  reserve  products 
of  the  community.  Since  in  the  majority  of  cases  this  function  in- 
volves "waiting,"  putting  an  interval  of  time  between  our  productive 
efforts  and  the  possession  of  product,  there  is  much  to  be  said  in 
favor  of  the  contention  that  waiting  is  the  true  function  of  capital  as 
capital ;  and  we  shall  often  employ  such  language. 

Distinctive  Peculiarity  of  Capital. — Having  isolated  the  dis- 
tinctive function  of  capital  as  capital,  we  are  in  a  position  to  isolate 
the  precise  peculiarity  about  capital  which  marks  it  off  as  something 
different  from  the  two  original  factors,  labor  and  land.  That 
peculiarity  is  the  fact  that  capital  as  a  fund  of  goods  represents, 
indicates,  embodies,  the  power  of  the  persons  who  are  the  actual 
or  virtual  owners  of  those  goods,  to  occupy  this  position, — the  power 
to  be  owners.  From  this  standpoint,  capital  as  capital  might  be 
defined  as  owning  or  "carrying"  power.  If,  on  the  other  hand,  we 
stress  the  point  of  view  which  sees  in  "waiting"  the  distinctive  func- 


V]  CAPITAL  AS  CAPITAL  73 

tion  of  capital  as  capital,  we  may  define  that  concept  as  "waiting- 
power"  I  shall  not  hesitate  to  employ  this  phrase  as  a  synonym 
or  substitute  for  owning  power.6  Going  a  step  deeper  to  the  first 
condition  lying  behind  the  power  to  own  or  "carry"  reserve  goods, 
we  may  say  that  the  distinctive  peculiarity  about  capital  is  the  fact 
that,  looked  at  as  a  mere  fund  of  goods  in  general,  wealth,  it  is  a 
surplus,  a  superfluity,  a  something  in  excess  of  the  needs  of  the 
immediate  present. 

Definition  of  Capital  as  Capital. — It  follows  from  the  above 
account  of  the  peculiarity  which  makes  capital  a  factor  independent 
of  labor  and  land  that  "capital  as  capital"  may  be  defined  as  the 
fund  of  reserve  goods  conceived  as  being  a  fund  of  wealth,  economic 
goods  in  general,  in  surplus,  in  excess  of  immediate  needs.  It,  of 
course,  has  no  existence  independently  of  those  goods :  it  is  merely 
those  goods  looked  at  in  one  special  way.  Obviously,  it  is  an  ab- 
straction. But  so  is  every  concept  an  abstraction.  When  we  think 
of  the  passengers  in  the  rear  seat  of  the  automobile  as  making  the 
machine  ride  more  steadily,  we  are  making  an  abstraction;  for,  of 
course,  these  persons  are  not  merely  ballast  to  our  car,  but  also 
human  beings,  who  love  and  hate,  have  joys  and  sorrows,  eat  and 
sleep,  work  and  rest,  and  so  on, — who,  in  short,  can  be  looked  at, 
thought  of,  in  a  vast  variety  of  ways  besides  that  one  which  for 
the  moment  is  of  interest  to  us,  that  is,  their  serving  to  steady  the 
car.  Abstractions  are  not  unreal  things,  but  merely  the  real  looked 
at  in  a  limited  way,  with  others  of  its  various  aspects  ignored. 

Capital  as  Capital  an  Economic  Factor. — In  noting  on  pages 
67-68  the  problems  which  the  capitalistic  method  of  production  in- 
volves, we  enumerated  a  third,  in  addition  to  the  two  which  have  just 
been  considered,  namely :  whether  the  element  which  we  have  isolated 
as  a  factor  additional  to  labor  and  land  is  also  an  economic  factor. 
This  question,  however,  was  necessarily  answered  by  implication 
when  we  established  the  reality  of  some  not  yet  isolated  factor  by 


*  I   do    not   believe,    however,    that   the    word    waiting   can    properly   be 
substituted   for  "saving"  as  expressing  the  process  by  which  capital  comes 


into  existence. 


74  PRINCIPLES  OF  ECONOMICS  [V 

showing  that  there  is  in  the  product,  and  so  of  necessity  in  the  pro- 
ductive process,  a  value  element  unaccounted  for;  since,  as  was 
brought  out  earlier,  the  possession  of  value  is  the  most  characteristic 
feature  of  an  economic,  as  distinguished  from  a  non-economic, 
factor.  It  is  not  necessary,  therefore,  to  show  that  the  factor  which 
we  have  isolated  as  additional  to  labor  and  land  is  an  economic  one. 
On  this  point,  there  is  no  room  for  difference  of  opinion. 

A  diagrammatic  illustration  of  the  theory  here  presented  as  to 
the  distinctive  office  of  capital  as  capital  is  given  in  Figure  8.  Let 
us  suppose  that  the  large  oval  in  the  upper  compartment  of  Figure  8 
represents  a  certain  quantity  of  labor,  while  the  heavily  shaded 
rectangle  connected  with  that  oval  by  the  arrow  pointing  from 
left  to  right  represents  the  amount  of  some  product  ready  for 
consumption  which  that  amount  of  labor  could  produce  by  a  direct, 
non-capitalistic  process,  and  without  appreciable  passage  of  time. 
In  contrast,  suppose  that  the  two  small  ovals  in  the  same  compart- 
ment represent  each  one-half  of  the  original  amount  of  labor;  that 
the  first  half  is  devoted  to  making  an  intermediate  product  which  is 
then  combined  with  the  second  half  of  the  labor  in  producing  the 
same  kind  of  consumption  product  as  before;  that,  when  our  original 
stock  of  labor  is  used  on  this  second  plan,  the  output  of  consump- 
tion product  is  forty  per  cent  larger  than  when  that  labor  is  used  on 
the  direct  plan ;  and  that  in  this  case,  as  in  the  preceding  one,  there 
is  no  appreciable  passage  of  time.  Since,  by  hypothesis,  the  time 
required  is  negligible  in  both  cases,  there  is  obviously  no  reason  why 
we  should  not  choose  the  second  more  efficient  method, — the  round- 
about method,  we  call  it, — and  of  course  we  should  do  so.  Such 
roundabout  methods  would  be  universally  employed;  the  whole 
product  would  be  credited  to  the  labor  used ;  and  there  would  be 
no  thought  of  trying  to  isolate  this  other  factor  which  we  call  "capital 
as  capital." 

But  it  is  hardy  necessary  to  say  that,  in  most  case$  of  round- 
about production,  the  facts  are  quite  different :  such  methods  not 
only  bring  a  great  increase  in  product,  they  also  usually  require 
periods  of  time  which  decidedly  are  appreciable,  while  the  periods 
required  in  direct  production  are  almost  negligible.  Thus  during  the 


V] 


CAPITAL  AS  CAPITAL 


75 


harvest  season,  at  any  rate,  the  dweller  in  a  sparsely  settled  district 
can  have  fruit  to  consume  which  he  has  gathered  but  a  moment 
before.  If,  in  contrast,  he  sets  out  to  provide  for  his  needs  in  this 
direction  by  the  indirect  process, — starting  a  berry  patch  or  an 
orchard,  bringing  it  to  maturity,  then  enjoying  the  crop, — he  must 
be  content  to  put  several  or  even  many  years  between  the  beginning 
of  the  process  and  its  final  fruition.  In  our  figure,  the  situation 


1924 


0 


1925 


1926 


£JO 


Figure  8.     Capital  as  Waiting  "Carrying"  Power  A 


thus  brought  about  is  represented  by  the  diagram  in  the  lower  com- 
partment, in  which  the  roundabout  process  presented  in  the  upper 
compartment  as  not  requiring  time  is  represented  as  taking  two 
full  years.  The  fact  that  this  new  situation  makes  it  necessary  that 
producers  should  be  provided  with  "carrying"  power,  waiting  power, 
is  indicated  by  the  two  horizonal  brackets  which  bridge  the  two 
intervals  of  one  year  each.  Just  as  the  horizontal  arrow  going 
from  the  first  labor  oval  to  the  lightly  shaded  square  and,  in  turn, 
the  arrow  going  from  this  square  and  the  second  oval  of  labor  to 
the  heavily  shaded  rectangle,  indicate  their  participation  in  the  pro- 


PRINCIPLES  OF  ECONOMICS 


[V 


ductive  processes,  so  the  little  vertical  arrows  dropping  down  to 
the  long  widening  arrows  which  terminate  in  the  intermediate  and 
final  product  indicate  the  participation  in 
the  productive  process  of  capital  as  capital, 
owning  power,  carrying  power,  waiting 
power. 

The  above  method  of  bringing  out  our 
doctrine  as  to  the  function  of  capital  as 
capital,  when  applied  to  the  whole  body  of 
products  belonging  to  a  community,  appears 
in  Figure  9.  Here  we  have  the  same  two 
rectangles  which  appear  in  Figure  I ;  this 
time  however,  the  large,  lightly  shaded 
rectangle  representing  the  fund  of  reserve 
goods,  is  inclosed  in  a  frame  having  a  ring 
at  the  top,  for  hanging  upon  a  hook  above. 
This  symbolizes  the  function  of  capital  in 
carrying,  owning,  upholding  the  fund  of 
reserve,  or  immediately  speaking,  idle 
wealth  which  is  necessary  to  the  high  ec- 
onomic efficiency  of  the  community.7 

ILLUSTRATIVE  PROBLEMS 
i.  Suppose  that  the  rectangle  in  Figure 
3  represents  a  dwelling  house  which  will 
last  just  20  years  and  so  will  give  off  twenty 
services  of  a  year's  duration  each,  and  that 
each  division  of  the  rectangle  represents  one 
of  these  twenty  annual  services.  What  would 


Figure  9.    Capital  as 

Waiting  "Carrying" 

Power  B 


be  the  function  of  capital  in  connection  with  such  a  dwelling?  Give 
some  reason  suggested  by  our  previous  discussions  why  a  family  that 
was  expecting  to  live  in  Ann  Arbor  for  four  years  would  prefer  to  rent 
such  a  house  rather  than  to  buy  it.  What  is  a  person  who  rents  such  a 
dwelling  for  four  years  virtually  doing? 

2.    Josiah  Wright,  the  wagon  maker,  is  making  a  lumber  wagon 
which  he  expects  to  sell  to  some  neighboring  farmer.    Now,  a  wagon 


*  For  some  differences  in  the  way  of  conceiving  capital  and  in  the  exten- 
sion given  the  term,  see  Note  i  of  the  Appendix. 


V]  CAPITAL  AS  CAPITAL  77 

is  undoubtedly  capital  or  capital  goods;  yet  in  making  that  wagon, 
Wright  is  not,  strictly  speaking,  producing  capital.  Explain  the  riddle. 
Show  that  Wright  for  various  reasons  needs  to  have  capital  himself  in 
order  to  be  a  producer  of  wagons. 

3.  "The  socialist  contention  that  producing  with  the  aid  of  capital, 
as  contrasted  with  producing  without  such  aid,  is  merely  employing  our 
labor  and  land  in  a  different  way,  though  suggesting  a  point  which  is 
correct,  is  after  all  inadequate."     Defend  that  statement. 

4.  In   an   economic   society   like  that   of   today,   new   capital   quite 
naturally  appears  first  in  the  form  of  accumulations  of  money  or  bank 
credit.     Argue  in  support  of  that  statement. 

II 
Capital  as  Responsibility-Taking  Power 

We  have  thus  far  recognized  only  three  classes  of  factors  the 
operation  of  which  conditions  the  existence  of  practically  any  and 
every  economic  product.  With  these  three,  economists  usually  stop. 
But  there  has  emerged  more  or  less  clearly  an  implicit  recognition 
of  a  fourth  factor,8  namely,  assuming  the  responsibility  of  produc- 
tion— willing  that  production  shall  go  on.  That  this  is  an  essential 
condition  is  obvious.  Failure  to  isolate  it  in  setting  forth  the  different 
factors  is,  perhaps,  due  to  the  fact  that  under  simple  industrial 
conditions  it  is  too  intimately  associated  with  one  or  more  of  the 
other  factors.  That  the  farmer  who  uses  his  land,  labor,  and  capital 
to  raise  wheat  must  will  to  raise  wheat  is  too  evident  to  need  com- 
ment,— indeed,  it  is  involved  in  saying  that  he  so  uses  them.  Is  it 
not,  then,  a  mere  fantastic  refinement  of  theory  to  separate  this 
function  in  the  total  process  from  the  rest?  The  reason  for  a 
negative  answer  is  not  far  to  seek.  The  plain  fact  is  that  the  more 
or  less  complete  separation  of  the  responsibility-taking  function 
from  the  other  functions  involved  in  production,  instead  of  being 
a  mere  refinement  of  the  theorist,  is  characteristic  of  actual  industrial 
practice.  The  men  who  are  responsible  for  the  producing  of  the 
vast  majority  of  goods  and  services,  outside  agricultural  products, 


It  seldom  appears  explicitly  in  discussing  the   factors  of  production. 


78  PRINCIPLES  OF  ECONOMICS  [V 

rarely  own  the  land  which  they  use,  perform  little  or  no  labor  them- 
selves, and  own  only  a  part,  anyhow,  of  the  capital  employed  in  the 
business.  This  would  seem  to  establish  pretty  conclusively  the  claim 
of  this  function  to  be  a  separate  one  in  the  productive  process, — to 

be  a  fourth  factor  in  production. 

......  -i 

Responsibility-Taking  Belongs  to  Capital. — It  must  not,  how- 
ever, be  overlooked  that,  under  the  present  order,  this  function, 
though  plainly  distinguishable  from  the  three  before  discussed,  is 
after  all  necessarily  connected  with  one  of  the  factors  already  treated, 
namely,  capital.  The  man  who  assumes  the  responsibility  of  willing 
that  production  shall  go  on  either  must  himself  supply  the  capital 
needed,  or  must  have  other  property  with  which  to  insure  the 
capitalists  from  whom  he  borrows;  since,  otherwise,  not  he  but 
they  would  assume  the  responsibility.  In  other  words,  the  function 
under  consideration  may  be  conceived  as  one  of  two  capitalistic 
functions, — the  two  being  (i)  the  "carrying"  of  the  reserves  (wait- 
ing) and  (2)  responsibility-taking.  In  any  case,  our  general  point 
is  evident  enough:  the  function  described  is  very  real,  is  absolutely 
necessary,  and  is  easily  distinguishable  from  the  one  which  we  have 
recognized  as  peculiarly  the  capitalistic  function,  that  is,  "carrying" 
the  reserves.  We  shall,  therefore,  recognize  it  as  a  fourth  factor 
in  production  without  further  effort  to  define  its  precise  relation  to 
capital  in  the  narrower  sense. 

An  Economic  Factor. — The  above  discussion  makes  it  clear 
that  assuming  the  responsibility  of  production  is  a  factor  in  pro- 
duction,— something  without  which  production  cannot  go  on.  But  it 
is  also  an  economic  factor;  for  it  commands  a  price.  The  men 
who  perform  this  service  must,  generally  speaking,  receive  a  profit 
in  return  for  their  services. 

Scope  of  This  Function. — This  function  of  responsibility- 
taking,  which  we  have  just  isolated,  involves  making  the  general 
decision  to  produce  in  the  field  chosen,  the  bearing  of  anxiety,  the 
assumption  of  various  kinds  of  risk,  and  a  limited  amount  of  man- 
aging,— so  much  as  is  incapable  of  delegation  to  persons  working 


V]  CAPITAL  AS  CAPITAL  79 

for  hire.  Such  a  function  is  plainly  the  most  vital  and  central 
in  the  whole  productive  process.  Nature  provides  material ;  labor 
provides  power  to  rearrange  the  material ;  capital  provides  carrying 
power,  enabling  these  materials  to  be  arranged  by  a  roundabout 
process;  yet,  though  all  these  were  present,  no  product  could  come 
into  existence  without  the  willing  that  the  required  rearrangement 
of  material  should  take  place.  The  will-to-produce  is  the  productive 
factor  par  excellence.  All  other  factors  contributing  to  a  business 
are  naturally  conceived  as  auxiliary  to  this ;  their  services  are  assem- 
bled and  combined  through  the  will-to-produce;  and  out  of  the  will- 
to-produce  emerges  directly  that  commodity  which  is  the  product  of 
the  business  taken  as  a  whole. 


ILLUSTRATIVE  PROBLEMS 

1.  "Discovery  and  invention  have  doubtless  played  a  very  large  part 
in  securing  our  present  high  industrial  efficiency.     But  they  are  not  the 
whole  thing.     The  increase  of  capital  has  been  equally  necessary ;  for, 
without  capital,   invention  could  have  accomplished  little  or  nothing." 
Defend  and  illustrate  the  last  sentence. 

2.  "The  common  pursuit  of  forestry  as  a  private  business  almost 
had  to  wait  until  capital  became  relatively  very  abundant."     Why  should 
this  be  true  of  forestry  more  than  of  wheat  raising? 

3.  The  following  is  taken  from  a  short  story  in  a  recent  number  of 
one  of  the  popular  magazines.     The  hero  inherited  great  wealth  in  roll- 
ing mills  and  has  for  several  years  successfully  continued  the  business. 
He  is  also  public-spirited  and  liberal.     Referring  to  his  charities,  the 
author  says: 

"What  was  it  that  he  had  given  ?  Something  that  he  ...  had  never 
earned.  His  hands  had  never  touched  belt  or  pulley.  He  looked  at  them 
curiously.  //  was  the  toil-hardened  hands  of  twelve  hundred  other  men 
that  made  his  giving  possible — the  hands  of  the  men  he  was  planning  to 
turn  off  on  Monday." 

Show  that,  if  this  was  a  normal  case,  we  could  impute  to  the  services 
of  the  twelve  hundred  workmen  only  a  part  of  the  net  output  of  the 
mills;  that  the  portion  going  to  the  proprietor  was  reasonably  enough 
credited  to  his  contribution  to  the  business.  Enumerate  several  elements 
which  probably  entered  into  his  contribution. 


8o  PRINCIPLES  OF  ECONOMICS  [V 

4.  "The  most  of  us  live  by  our  wits — spend  our  time  wheedling  the 
true  producers,  the  men  who  work  with  their  hands,  into  sharing  with 
us  the  things  which  they  produce." 

Give  several  illustrations  of  kinds  of  labor  necessary  to  production 
which  would  not  naturally  be  described  as  working  with  one's  hands. 

5.  Some  writers  have  been  disposed  to  affirm  that,  in  the  last  analysis, 
all  capital  gets  its  start  in  a  surplus  of  the  means  of  subsistence,  par- 
ticularly food.     This  undoubtedly  has  considerable  force  as  applied  to 
primitive   conditions.     Illustrate   the    proposition    for   a   community   of 
fishermen. 


CHAPTER  VI 

THE  DIFFERENT  AGENTS  IN  PRODUCTION 

The  preceding  discussion  has  dealt  with  the  fundamental  or 
primary  factors  employed  in  productive  processes.  But,  obviously, 
the  control  of  these  several  factors  must  be  in  the  hands  of  human 
beings,  else  they  would  not  be  economic  factors.  Accordingly,  we 
are  able  to  name  a  class  of  producers,  of  human  agents  in  production 
corresponding  to  each  of  the  different  factors.  This  classification  has 
already  been  anticipated;  but  a  more  explicit  reference  seems  de- 
sirable. 

The  Laborer. — The  agent  in  production  corresponding  to  the 
first  factor  is,  of  course,  the  laborer, — the  human  individual  who 
furnishes  services  which  are  the  product  of  his  own  effort.  It  makes 
no  difference  whether  the  services  are  of  physical  or  intellectual  char- 
acter ;  it  makes  no  difference  whether  they  are  of  the  humblest 
sort,  or  of  the  greatest  and  most  conspicuous,  the  man  who  furnishes 
them  is  a  laborer.  Promoting  is  labor,  and  managing  is  labor,  as 
we  have  seen ;  and  the  promoter  and  the  manager  are  therefore 
laborers;  the  $100,000  president  of  a  corporation  is  a  laborer  as 
truly  as  his  office  boy  or  the  mason  building  his  walls  or  the 
machinist  in  his  shops. 

The  Landlord. — Just  as  the  laborer  is  the  human  agent  in 
production  corresponding  to  the  element  or  factor  called  labor,  so 
the  agent  corresponding  to  the  factor  called  land  is  the  land  owner 
or  landlord.  The  landlord  is  the  individual  who  furnishes  for  pro- 
ductive purposes  the  use  of  land  or  land  services.  It  is  possible, 
as  we  conceded  in  the  preceding  section,  to  have  an  economic  order 
in  which  land  owning  is  not  permitted,  and  therefore  one  in  which 
this  agent  of  production  is  not  represented  by  any  private  individual. 

8l 


82  PRINCIPLES  OF  ECONOMICS  [VI 

But  it  is  not  now  possible,  nor  has  it  been  possible  since  the  very 
beginning  of  society,  to  have  an  order  in  which  there  was  not  some 
sort  of  landlord  present  as  an  agent  in  production.  At  the  first 
moment  any  part  of  the  existing  land  comes  to  be  wanted  by  more 
than  one  person,  at  that  moment  it  acquires  value,  and  takes  on  the 
character  of  an  economic  good.  Someone  then  inevitably  appro- 
priates it  in  order  to  reap  the  advantage  of  its  superior  desirableness ; 
this  someone  may  be  an  individual  person  or  the  community  as  a 
whole;  but,  whether  one  or  the  other,  we  will  certainly  have  to 
secure  his  participation  before  we  can  utilize  the  land  as  a  factor 
in  production.  Such  was  the  course  of  events  in  early  societies, 
and  such  will  always  be  their  course.  Undoubtedly  we  can  if  we 
like  substitute  public  for  private  landlords ;  but  the  landlord  is  still  a 
necessary  agent  in  production,  and  we  can  never  get  rid  of  him. 

In  saying  that  a  landlord  is  present  in  every  productive  act,  we 
do  not  of  course  mean  to  imply  that  he  always  exists  as  a  distinct 
person.  The  land  factor,  as  we  have  pointed  out,  is  a  different  thing 
in  its  nature  and  in  its  contribution  from  the  labor  factor.  But 
this  is  not  to  say  that  the  land  and  labor  cannot  be  controlled  simul- 
taneously by  the  same  person.  On  the  contrary,  it  is  very  common 
for  the  laborer  to  furnish  his  own  land  and  for  the  landlord  to 
perform  his  own  labor — a  perfect  example  being  that  of  a  farmer 
or  gardener  who  tills  the  soil  he  himself  owns.  Nevertheless,  in 
admitting  the  presence  of  the  two  agents  in  the  same  person,  we 
by  no  means  reduce  the  two  agents  to  one.  To  the  extent  that  a 
man  labors,  he  is  a  laborer,  just  as  if  he  owned  not  a  foot  of  land; 
and,  for  all  the  land  he  furnishes,  he  is  a  landlord,  just  as  if  he 
performed  no  labor  whatever. 

The  Capitalist  Proper. — The  third  agent  in  production  is  the 
capitalist,  the  individual  who  owns,  "carries,"  the  reserve  goods  of 
the  community.  The  capitalist  does  not  labor ;  he  does  not  furnish 
land;  he  does  not  assume  the  responsibility  of  making  the  business 
go;  and,  generally  speaking,  he  does  not  even  put  at  risk  his  prin- 
cipal or  the  income  therefrom.  As  capitalist,  he  simply  supplies 
the  surplus  which  constitutes  the  carrying  power  or  waiting  power 
necessary  to  make  possible  the  use  of  roundabout  methods  of  pro- 


VI]  THE  DIFFERENT  AGENTS  IN  PRODUCTION  83 

duction.  The  use  of  "capitalist"  in  this  definition  is  highly  tech- 
nical, and  subject  in  some  degree  to  the  charge  of  arbitrariness. 
But  it  is  no  more  so  than  the  best  of  the  others  which  we  might 
adopt;  and,  because  of  its  practical  utility  in  the  further  analysis 
of  our  subject,  we  shall  regard  it  as  correct. 

It  is  hardly  necessary  to  remark  that  the  same  person  may  be  a 
capitalist,  a  landlord,  and  a  laborer.  Men  who  own  buildings  and 
machinery  very  frequently  own  the  land  upon  which  they  operate, 
and  also,  as  laborers,  attend  to  the  operation  of  these  intermediate 
goods.  The  farmer  is  the  most  obvious  of  many  examples  of  a  man 
who  is  capitalist,  landlord,  and  laborer  in  one. 

But,  while  we  recognize  the  possibility  of  a  coalescing  of  the 
different  agents  into  one,  the  emphasis,  especially  as  regards  the 
capitalist  and  the  laborer,  should  perhaps  be  placed  on  a  contrary 
tendency.  In  a  state  of  primitive  industry,  laborers  almost  uni- 
versally own  their  tools,  and  men  who  own  tools  are  also  the  wielders 
of  them.  But  modern  conditions  of  production  tend  more  and  more 
to  separate  the  two  agents.  The  amount  of  capital  required  for 
a  modern  business  undertaking  is  very  great,  the  carrying  of  a 
single  machine,  which  a  single  laborer  can  operate,  often  repre- 
senting the  tying  up  of  thousands  of  dollars  of  purchasing  power. 
T*he  ordinary  laborer  cannot  by  any  effort  of  saving  accumulate  a 
great  enough  fund  of  money  to  engage  in  this  sort  of  production, 
and  accordingly  the  saving  is  and  must  be  done  by  other  people 
who  perhaps  perform  little  labor  in  the  ordinary  sense.  And  even 
when  laborers  do  save  something  from  their  incomes,  the  accumula- 
tions seldom  make  them  masters  of  the  particular  tools  they  use. 
Their  money  is  deposited  in  a  bank,  and,  by  a  process  to  which  we 
shall  give  more  attention  later  on,  establishes  them  as  part  capitalists 
in  concerns  other  than  those  where  they  are  employed,  and  usually 
in  concerns  of  which  they  have  no  knowledge. 

But,  even  if  there  were  no  such  tendency  as  the  one  just  de- 
scribed, even  if  the  three  agents  existed  usually  in  the  same  in- 
dividual, this  fact  would  not,  in  our  logical  analysis,  reduce  the 
three  agents  to  one.  In  so  far  as  a  man  labors  he  is  a  laborer ;  in 
so  far  as  he  furnishes  land,  he  is  landlord ;  in  so  far  as  he  furnishes 
carrying  power,  he  is  a  capitalist. 


84  PRINCIPLES  OF  ECONOMICS  [VI 

The  Entrepreneur. — The  primary,  central  factor  in  produc- 
tion is  responsibility-taking ;  hence  the  primary,  central  agent  in  pro- 
duction is  the  person,  natural  or  legal,  who  supplies  this  factor. 
Adam  Smith  (1776)  called  this  person  the  undertaker,  a  designa- 
tion now  out  of  vogue.  Recently  some  writers  have  taken  to  using 
a  newly-coined  term,  enterpriser.  But  most  writers  using  the 
English  language  nowadays  employ  the  French  equivalent  of  Adam 
Smith's  term,  the  word  "Entrepreneur." . 

The  Entrepreneur  is  the  agent  who  assumes  responsibility  in 
productive  undertakings.  If  our  analysis  of  economic  factors  has 
been  understood,  little  further  exposition  will  be  required  at  this 
point.  The  entrepreneur  is  not  a  laborer  but  an  employer  of  labor ; 
he  is  not  a  landlord,  but  a  renter  of  land;  he  is  not  capitalist,  but 
a  borrower  of  capital.  He  rents  from  the  landlord,  borrows  from 
the  capitalist,  and  hires  a  body  of  laborers ;  and,  marshaling  together 
the  elements  obtained  from  these,  he  institutes  production. 

Function  of  Entrepreneur  Complex. — It  should  be  remarked, 
however,  that  the  division  of  functions  cannot  be  so  precise  in  the 
case  of  the  entrepreneur  as  in  that  of  any  other  agent.  Even  as 
entrepreneur,  he  cannot  divest  himself  of  functions  which,  from 
their  nature,  seem  to  belong  to  labor  or  capital.  It  is  true  that  most 
of  the  labor  furnished  by  some  entrepreneurs  could  usually  be  per- 
formed quite  as  well  by  laborers  they  could  hire.  In  respect  to 
labor  of  this  sort,  therefore,  the  entrepreneur  is  merely  a  laborer. 
But  certain  duties  he  can  escape  only  by  ceasing  to  be  an  entrepre- 
neur, for  example,  appointing  the  higher  director  or  managers  of 
the  business,  and  making  certain  final  decisions  with  respect  to  the 
conduct  of  the  business.  These  acts  constitute  labor  as  we  ordinarily 
understand  it,  the  putting  forth  of  personal  effort.  Yet  the  entre- 
preneur does  not  therefore  classify  as  a  laborer;  for  these  acts 
cannot  be  performed  by  a  true  laborer,  but  are  inseparable  from  his 
functioning  as  entrepreneur ;  in  performing  them  he  is  not  less,  but 
rather  more,  of  an  entrepreneur.  A  similar  complication  arises  in 
the  furnishing  of  capital.  An  entrepreneur  may  and  usually  does 
put  some  of  his  own  capital  into  a  business.  With  respect  to  that 
capital,  he  may  be  thought  of  as  both  capitalist  and  entrepreneur. 


VI]  THE  DIFFERENT  AGENTS  IN  PRODUCTION  85 

By  means  of  it,  he  is  in  part  furnishing  the  service  of  waiting 
necessary  to  the  conduct  of  the  business.  He,  therefore,  credits  to 
himself  interest  on  this  capital  just  as  he  would  pay  it  to  a  lender. 
But  the  same  capital  serves  in  part  as  the  basis  of  his  power  to 
perform  his  distinctive  office  as  entrepreneur,  that  is,  assuming 
the  responsibility  and  risk  of  production.  He,  therefore,  expects  the 
entrepreneur's  remuneration  on  this  capital,  in  addition  to  the  in- 
terest he  receives  on  it  as  a  mere  capitalist.  In  other  words,  in 
respect  to  that  portion  of  the  capital  which  he  himself  supplies,  he 
is  both  capitalist  and  entrepreneur,  and  gets  pay  for  both  types  of 
service.1 


Corporate  Entrepreneurs. — It  is  sometimes  necessary  to  dis- 
tinguish different  kinds  of  entrepreneurs,  namely,  the  individual  and 
the  collective  entrepreneur.  The  term,  individual  entrepreneur,  as 
an  entrepreneur  existing  in  a  single  person,  sufficiently  defines  it- 
self. The  collective  entrepreneur  may  exist  in  any  one  of  the  legal 
business  entities  such  as  the  Partnership,  the  Joint  Stock  Company,  or 
the  Corporation. 

In  the  case  of  industries  undertaken  by  corporations,  the  cor- 
poration as  such,  the  'collective  unit,  is  from  the  standpoint  of 
formal  logic  the  true  entrepreneur.  But  cautious  interpretation  is 
here  necessary.  The  corporation,  acting  through  its  usual  organs, 
the  president,  the  secretary,  and  general  manager,  cannot  be  the 
entrepreneur,  because  these  organs  are  created  by  a  more  fundamental 
power,  the  board  of  directors.  Again,  the  corporation  acting  through 
the  board  of  directors  cannot  be  the  real  entrepreneur,  because  that 
body  is  created  by  a  power  still  more  fundamental,  the  general  meet- 
ing of  stockholders.  When  at  last  we  reach  the  general  body  of 
stockholders,  acting  in  the  way  prescribed  by  their  charter  for  the 
decision  of  vital  questions,  we  are  in  the  presence  of  something 


1  In  this  analysis,  if  the  entrepreneur  gets  fifteen  per  cent  on  the  invest- 
ment, five  or  six  of  this  must  be  reckoned  as  interest,  only  the  remainder 
as  true  profits.  In  practical  business,  it  is  more  usual  to  think  of  the  whole 
fifteen  per  cent  as  profits,  though  most  business  men  would  at  once  admit  the 
theoretic  propriety  of  dividing  that  fifteen  per  cent  into  different  parts :  true 
interest  and  true  profits. 


86  PRINCIPLES  OF  ECONOMICS  [VI 

which  may  fairly  be  called  ultimate, — there  is  nothing  behind  to  de- 
termine its  action.  This  general  body  of  stockholders,  therefore, 
should  probably  be  recognized  as  the  true  claimant  for  the  title  and 
functions  of  entrepreneur.  In  some  respects,  on  the  other  hand, 
the  stockholders  as  a  mere  aggregate  of  individuals  seem  best  to 
deserve  the  title ;  particularly  since  the  starting  of  a  corporate  under- 
taking, determining  whether  or  not  the  industry  shall  be  carried 
on  at  all — the  taking  of  ultimate  responsibility  for  production — 
rests  with  investors  as  individuals,  not  with  the  body  of  stockholders 
formally  organized.  Accordingly,  for  some  purposes  we  have  to 
locate  the  entrepreneur  of  a  corporation  in  the  stockholders  formally 
organized,  while  for  other  purposes  we  must  recognize  this  agent 
in  the  mere  aggregate  of  stockholders. 

Functions  of  Different  Agents  Combined. — Finally,  we  must 
say  of  the  entrepreneur  what  we  have  said  of  all  the  other  agents, 
that  he  does  not  necessarily  exist  apart  as  a  separate  individual, 
natural  or  legal.  Illustrations  will  at  once  occur  of  men  who  are 
entrepreneur,  capitalist,  landlord  and  laborer  all  in  one.  In  fact, 
there  probably  never  is  in  the  real  world  any  such  complete  separa- 
tion and  specialization  of  the  different  agents  as  might  be  suggested 
by  the  foregoing  analysis.  But,  in  any  case,  the  point  already 
much  emphasized  must  be  remembered,  that,  even  where  all  agents 
exist  in  a  single  person,  they  are  logically  distinct,  because .  their 
functions  are  distinct.  As  a  laborer,  the  man  labors;  as  a  landlord, 
he  furnishes  land;  as  a  capitalist  he  furnishes  waiting  power;  and 
as  an  entrepreneur  he  furnishes  responsibility-taking,  an  element 
which  includes  a  small  residuum  of  labor  and  waiting. 

The  Entrepreneur  the  Producer. — To  conclude  this  discussion 
let  us  repeat  what  has  before  been  clearly  hinted  at,  regarding  the 
relation  of  the  different  agents.  The  cooperation  of  all  the  agents 
is  required  in  practically  all  productive  undertakings ;  and,  since 
there  are  no  degrees  in  necessity,  it  would  be  incorrect  to  say  that 
one  is  more  necessary  than  the  others.  Nevertheless,  the  last  agent 
discussed,  the  entrepreneur,  does  stand  in  a  peculiarly  significant 


VI]  THE  DIFFERENT  AGENTS  IN  PRODUCTION  87 

relation  to  all  the  others  and  to  the  product.  In  a  sense,  he  merely 
employs  the  other  agents  as  his  auxiliaries,  and  he  is  responsible 
for  the  product.  Hence,  in  the  ordinary  way  of  thinking,  we 
esteem  him  as  more  important  than  the  other  agents.  In  recogni- 
tion of  this  judgment  we  shall  call  the  entrepreneur  the  producer 
par  excellence,  and  where  "producer"  is  used  in  the  later  pages  of 
this  volume  without  qualification,  it  will  be  an  entrepreneur  whom 
we  have  in  mind. 

ILLUSTRATIVE  PROBLEMS 

1.  "In   cooperative   production    (meaning   production   in   which   the 
workmen  own  the  business)  the  place  of  the  entrepreneur  is  taken  by  a 
manager  elected  by  the  workmen." — Textbook.     Criticize.     How  is  the 
entrepreneur  constituted  in  cooperative  production? 

2.  "Today,  all  over  the  land,  masons,  hod  carriers,  carpenters,  and  so 
on,  are  building  palaces  which  other  people  are  to  live  in.     When  so- 
cialism triumphs,  all  this  will  be  changed.     The  worker,  no  longer  robbed 
of  the  fruits  of  his'  labor,  will  himself  occupy  the  palaces  he  builds, 
wear  the  broadcloth  he  makes,  and  eat  the  choice  viands  he  produces." 

(a)  Does  justice  require  that  the  worker  should  have  the  right  to 
consume  the  particular  object  he  expends  effort  on?     Explain. 

(b)  If  it  did,  would  the  particular  set  of   workers — masons,   hod 
carriers,  carpenters,  and  so  on — who  construct  the  palace  have  the  ex- 
clusive right  to  enjoy  it?     Explain. 

(c)  Show  that  other  persons  besides  "workers"  in  the  sense  here 
used  have  supplied  conditions  necessary  to  the  existence  of  the  palace. 

3.  Until  recently  it  was  usual  to  teach  that  the  peculiar  function  of 
the  entrepreneur  is  to  manage,  direct,  industry.     One  feature  of  modern 
industrial  organization  almost  compels  us  to  reject  this  idea.     Explain. 

4.  "Postponing  consumption  so  that  production  may  be  carried  on  in 
a  roundabout  way  is  the  function  of  the  capitalist." — Textbook.     Ex- 
plain and  illustrate. 

5.  Why  do  we  say  that  every  stockholder  of  a  corporation  is  an 
element  in  the  corporate  entrepreneur  while  a  bondholder,  who  also  has 
capital  in  the  concern,  is  not? 

6.  Not  many  years  ago  Mr.  W,  after  some  months  of  painstaking 
negotiations,  induced  a  number  of  persons  owning  certain  lands  on  the 


88  PRINCIPLES  OF  ECONOMICS  [VI 

Copper  Range  to  join  with  him  in  organizing  a  corporation  to  build  a 
railroad,  open  mines,  etc., — Mr.  W  putting  in  some  land  of  his  own. 
For  his  fee,  Mr.  W  was  to  receive  a  certain  number  of  shares  in  the 
stock  of  the  company. 

Distinguish,  with  explanations,  the  two  economic  roles  played  by  Mr. 
W  in  this  matter. 


CHAPTER  VII 

GENERAL  CONDITIONS  OF  PRODUCTIVE 
EFFICIENCY 

Production,  as  we  have  seen  in  the  preceding  chapter,  is  accom- 
plished by  the  united  action  of  several  different  factors.  Pro- 
ductive efficiency,  the  subject  of  the  present  chapter,  means  a  con- 
dition or  state  of  economic  production  in  which  the  employment  of 
a  given  quantity  of  these  different  factors  results  in  a  relatively  large 
or  desirable  product. 

That  a  high  degree  of  efficiency  should  be  maintained  is,  of 
course,  directly  to  the  interest  of  the  entrepreneur  in  charge  of 
any  industrial  enterprise.  But  it  is  also  to  the  interest  of  every 
person  in  the  community.  By  the  very  first  principle,  formulated 
in  Chapter  II,  every  person  (or  community)  in  a  cooperative  order 
such  as  ours,  tends  to  gain  from  any  increase  in  the  economic  effi- 
ciency of  other  persons  or  communities  with  which  economic  rela- 
tions are  maintained;  and,  directly  or  indirectly,  every  person  in 
our  system  maintains  such  relations  with  every  other  person. 
Doubtless  the  extent  to  which  individuals  profit  personally  from 
such  efficiency  is  subject  to  great  variation;  but  we  can  scarcely  con- 
ceive of  anyone  so  situated  that  he  would  not  gain  something. 
It  becomes  pertinent  therefore  to  make  some  inquiry  into  the  laws 
and  principles  under  which  production  may  attain,  and  remain  in, 
a  state  of  high  efficiency. 

At  the  outset  of  this  inquiry,  however,  it  should  be  noted  that 
Economics  does  not  attempt  an  exhaustive  investigation  into  the 
technical  conditions  of  productive  efficiency.  In  its  study  of  agri- 
culture, for  example,  it  does  not  concern  itself  directly  with  fertiliza- 
tion, drainage,  and  rotation ;  nor,  in  its  study  of  manufacturing, 
does  it  touch  upon  power  generation,  the  choice  and  placing  of 
machinery,  and  the  like.  These  problems  lie  rather  within  the 
special  province  of  the  technical  arts  themselves ;  they  are  problems 

SQ 


90  PRINCIPLES  OF  ECONOMICS  [VII 

of  agriculture  and  manufacturing,  not  of  Economics.  The  field  of 
Economics  lies  deeper.  It  embraces  the  more  general  principles 
which  underlie  and  govern  the  purely  technical  phenomena  of  all 
the  arts  alike.  Let  us  begin  with  a  broad  survey  of  these  prin- 
ciples, and  continue  with  a  more  particular  examination  of  some 
of  them  in  their  relation  to  the  different  economic  factors. 

I 
Capitalistic  Methods 

One  clearly  established  principle  is  that  industries  can  usually 
increase  their  productive  efficiency  by  the  introduction  of  methods 
which  employ  a  large  amount  of  capital.  Methods  using  some 
capital  are  probably  without  exception  better  than  methods  using 
none;  and,  as  a  rule,  methods  using  much  are  better  than  those 
using  little. 

In  our  day  practically  all  production  is  capitalistic.  There  are 
to  be  sure  marked  differences  in  the  degree  to  which  capitalism  is 
carried  in  various  industries.  Some  industries,  from  their  very 
nature,  seem  able  to  use  more  capital  than  others  located  in  the 
same  city  or  country ;  and  the  industries  in  one  city  or  country  may, 
in  general,  use  more  than  those  in  another.  But,  however  great 
these  variations,  the  fact  remains  that  most  industries  can  use  all 
the  capital  available,  and  the  more  they  use  the  higher  is  the  pro- 
ductive efficiency  to  which  they  attain. 

Utilize  Natural  Powers. — The  principal  explanation  of  this 
increase  in  efficiency  is  to  be  found  in  the  fact  that,  through  the 
roundabout  method,  men  are  able  to  reinforce  their  own  powers 
with  the  powers  of  nature,  and  thus  to  rearrange  the  materials  upon 
which  they  work  with  relatively  greater  speed  and  precision.  In 
the  beginnings  of  industry,  when  the  primitive  fisherman,  for  ex- 
ample, made  a  net  and  a  boat  to  use  in  catching  fish  instead  of 
depending  on  his  naked  hands  alone,  the  gain  in  efficiency  was 
enormous;  and  even  in  later  stages  of  industrial  development  some 
invention  like  the  steam  engine,  the  dynamo,  or  the  cotton  gin,  gives 
to  our  productive  efficiency  an  increase^  startlingly  great.  These 


VIII  PRODUCTIVE  EFFICIENCY  91 

facts  would  seem  to  be  so  familiar  as  to  need  little  comment.  Still 
they  are  not  infrequently  overlooked  in  times  of  popular  excitement ; 
and  legislative  measures  are  adopted  and  enforced  which  discourage 
the  accumulation  of  capital  or  drive  it  out  of  the  community.  It 
was  needful,  therefore,  that  the  point  should  receive  some  em- 
phasis. 

II 
Specialization 

We  saw  in  Chapter  II  that  the  present  economic  order  is  one  of 
heterogeneous  cooperation,  wherein  each  person  specializes ;  and 
that  each  individual  in  the  system  finds  this  specialization  advan- 
tageous because  it  enables  him  to  enjoy  more  goods  and  a  greater 
variety  of  goods,  and  goods  of  better  quality  than  he  possibly  could 
if  he  attempted  to  produce  everything  for  himself.  Now,  of  course, 
the  primary  reason  why  specialization  enables  the  consumer  to  con- 
sume more  and  better  goods  is  that  it  enables  the  producer  to  pro- 
duce more  and  better  goods.  We  have  thus  already  clearly  implied 
that  specialization  is  one  chief  source  of  productive  efficiency.  Let 
us  now  consider  this  point  a  moment  from  the  producer's  standpoint 
as  we  formerly  did  from  the  consumer's. 

Utilizes  All  Agents. — In  the  first  place,  specialization  utilizes 
all  agents  and  instruments  of  production,  even  the  inferior  ones. 
It  splits  up  our  complex  industrial  processes,  dividing  the  small 
tasks  from  the  great ;  so  that  a  person  who  cannot  perform  a  whole 
process,  because  he  is  incapable  of  doing  the  difficult  part  of  it, 
may  nevertheless  contribute  something  to  the  whole  because  he  is 
capable  of  doing  the  easy  part.  Thus  a  boy  who  would  be  quite 
helpless  as  the  manager,  machinist,  or  salesman  of  a  concern,  may 
make  himself  very  useful  running  errands.  On  the  other  hand, 
specialization  utilizes  superior  instruments  and  agents  most  fully. 
A  steam  locomotive  designed  for  pulling  forty  of  fifty  loaded 
freight  cars  across  the  country  at  thirty  miles  an  hour  is  kept 
constantly  moving  in  that  service,  while  lighter  trains  in  the  terminal 
are  handled  by  locomotives  of  smaller  power;  a  skilful  surgeon 


92  PRINCIPLES  OF  ECONOMICS  [VII 

need  not  trifle  away  his  time  at  mowing  the  lawn  or  going  to  the 
newspaper  office  for  his  paper — he  can  abandon  those  tasks  to 
inferior  agents  and  devote  all  his  skill  to  dangerous  operations  in 
the  hospital. 

Utilizes  Aptitudes,  Natural  or  Acquired. — Specialization 
utilizes  natural  aptitudes,  especially  in  the  land  and  labor  factors. 
A  man  endowed  with  a  mechanical  genius  is  kept  busy  at  mechanics, 
instead  of  being  required  to  cultivate  corn ;  and  land  that  will  raise 
fifty  bushels  of  wheat  to  the  acre  is  reserved  for  that  valuable 
product  instead  of  being  given  up  in  part  to  forestry  or  grazing. 
Specialization  also  permits  the  development,  in  the  labor  and  capital 
factors,  of  artificial  aptitudes.  A  pianist  can  greatly  improve  the 
flexibility  of  his  hands,  and  consequently  his  skill  as  a  player,  from 
the  fact  that  he  is  permitted  to  refrain  from  heavy  manual  labor 
and  spend  long  hours  at  finger  exercises  on  the  keyboard.  About 
the  only  implement  the  primitive  man  possessed  was  the  knotted 
stick,  and  he  could  use  it  to  destroy  his  enemies,  to  grind  his  corn, 
to  pillow  his  head  at  night,  and  for  numberless  other  purposes.  But, 
viewed  from  the  modern  standpoint,  the  implement  was  not  well 
adapted  to  any  of  those  purposes;  and  specialization  has  given  us 
thousands  of  different  implements,  creating  in  each  a  special  apti- 
tude for  one  kind  of  work.  Again,  specialization  economizes  in 
time  for  men  and  machines,  since  it  eliminates  the  loss,  often  very 
large  in  the  aggregate,  of  changing  from  one  task  to  another.  It 
also  shortens  the  period  of  apprenticeship  or  education — a  man  can 
learn  to  be  a  skilful  mason  more  quickly  than  he  can  learn  to  be 
both  a  mason  and  a  carpenter.  Finally,  specialization  stimulates 
invention — a  man  devoting  himself  completely  to  one  particular  job 
and  learning  all  the  niceties  of  it  will  find  more  ways  of  improving 
his  performance  than  a  man  working  now  here,  now  there,  on  a 
dozen  different  jobs. 

Use  Depends  on  Extent  of  Market. — We  have  just  seen  that 
specialization  contributes  greatly  to  productive  efficiency.  It  fol- 
lows that  the  full  realization  of  any  condition  requisite  to  such 
specialization  must  contribute  to  productive  efficiency.  Now,  as 


VII]  PRODUCTIVE  EFFICIENCY  93 

pointed  out  at  the  very  beginning  of  our  study,  one  such  condition 
is  exchange.  Under  the  present  system,  specialization  and  the  co- 
operation it  involves  is  made  possible  chiefly  through  exchange. 
That  is,  in  order  to  take  advantage  of  the  principle  that  specializa- 
tion increases  efficiency,  we  must  exchange  products  with  one  an- 
other. It  follows  that  the  degree  to  which  this  specializing  can  be 
carried  depends  on  the  extent  of  our  exchanging.  If  we  trade  with 
only  a  few  people,  the  need  for  a  single  kind  of  goods  will  be  too 
small  to  justify  any  one  of  us  in  producing  that  kind  only.  Thus, 
the  man  who  calls  himself  a  barber  in  a  small  town  can  do  most 
of  the  barbering  which  his  neighbors  require  at  night  and  on 
Saturday  afternoon;  and  the  rest  of  the  time  he  must  fill  in  as  he 
can,  mending  shoes,  soldering  tin  pans,  or  lending  a  hand  on  odd 
jobs  at  the  garage.  He  cannot  specialize  in  barbering,  or  in  any  one 
of  his  other  trades,  because  the  amount  of  service  wanted  by  the 
community  with  which  he  exchanges  is  not  large  enough  to  keep  him 
busy.  Hence  we  have  the  following: 

Principle.  The  extent  to  which  productive  efficiency  can 
be  increased  by  means  of  specialization  varies  directly  as  the 
extent  of  the  market. 

Freedom  of  Trade  Desirable. — The  foregoing  principle  sug- 
gests one  of  the  chief  reasons  why  economists  as  a  class  are  free- 
traders. They  favor  the  utmost  possible  freedom  from  restrictions 
because  this  allows  the  largest  amount  of  cooperation  and  thereby 
enables  everyone  to  benefit  most  completely  by  the  productive  ac- 
tivity of  everyone  else.  All  economists,  of  course,  would  admit 
that  free  trade  in  some  commodities  is  more  important  than  in 
others,  just  because  trade  of  any  sort  in  some  commodities  is  more 
important  than  in  others.  An  import  duty  on  hay  would  for  some 
years  not  affect  us  one  way  or  another — it  would  be  a  mere  futility, 
since  we  do  not  normally  buy  much  hay  outside  our  own  country. 
In  contrast  with  this  case,  any  departure  from  freedom  in  steel 
goods,  textiles,  and  sugar  is  sure  to  have  notable  results,  because 
we  naturally  import  those  things  in  large  amounts.  But,  whether  we 
deal  in  a  commodity  much  or  little,  the  privilege  of  trading  with- 


94  PRINCIPLES  OF  ECONOMICS  [VII 

out  restrictions  when  we  see  an  advantage  will  conduce  to  the  pro- 
ductive efficiency  of  all  the  countries  concerned.  Hence  the  follow- 
ing corollary : 

Corollary.       High  productive  efficiency  depends  on  a 
large  amount  of  freedom  of  trade. 

ILLUSTRATIVE  PROBLEMS 

1.  "Our  very  large  output  enables  us  to  make  each  man  a  specialist 
in  his  line  of  work." — Willard  Storage  Battery  Company.    Why? 

2.  In  most  economic  textbooks,  one  meets  the  phrase  "geographical 
division  of  labor." 

(a)  What  do  you  suppose  it  means? 

(b)  Give  some  illustrations  of  it. 

3.  Give  some  examples  of  recently  developed  labor  specialization, — 
if  possible  from  your  own  observation. 

4.  Same  as  Problem  3  for  capital. 

5.  Why  is  it  that  a  country  store  keeps  a  little  of  everything,  while 
a  city  store  very  often  deals  in  only  one  kind  of  commodity,  e.  g.,  shoes  or 
china  or  sporting  goods? 

6.  It  is  sometimes  said  that  nowadays  almost  everything  is  produced 
for  a  world  market. 

(a)  What  is  one  of  the  greatest  gains  of  having  such  a  market? 

(b)  What  are  some  of  the  most  important  industrial  changes  which 
have  made  it  possible? 

(c)  Suggest  one  or  two  of  the  most  serious  evils  which  would 
naturally  result  from  it. 

Ill 
Large  Scale  Production 

It  is  a  fact  familiar  to  all  of  us  that  the  extraordinary  industrial 
progress  of  the  last  hundred  years,  and  particularly  of  the  last 
twenty-five  years,  has  been  accompanied  by  a  great  expansion  in  the 
scale  on  which  industry  is  conducted.  On  the  one  side,  the  total 
output  of  commodities  has  greatly  increased,  their  quality  has,  in 
general,  been  improved,  and  their  price  lowered — so  that  today 


VII]  PRODUCTIVE  EFFICIENCY  95 

men  who  are  considered  poor  may  enjoy  comforts  which  a  hundred 
years  ago  would  have, been  envied  by  kings.  On  the  other  side, 
we  find  that  the  establishments  which  produce  these  commodities 
are  not  so  numerous  as  they  were  twenty-five  or  fifty  years  ago, 
but  that  the  individual  establishments  now  producing  are  in  size, 
as  compared  to  the  old  ones,  very  much  larger.  These  two  phe^ 
nomena,  it  is  generally  recognized,  have  been  in  some  measure 
related  as  effect  and  cause ;  our  industrial  progress  has  partly  resulted 
from  the  enlarged  scale  of  the  producing  operations.  The  big 
store,  the  big  factory,  the  big  railroad  has  been  able  to  supply  its 
particular  product  in  greater  volume,  at  much  smaller  cost,  and  often 
of  much  better  quality.  Large  scale  production  has  meant  more 
efficient  production. 

Increased  Specialization  Possible. — Among  the  principal  rea- 
sons for  the  superiority  of  large  scale  production  are  the  following: 
Large  scale  production  permits  a  great  extension  of  the  policy  of 
specialization.  That  this  policy  greatly  increases  productive  effi- 
ciency has  already  been  brought  out.  The  particular  form  of 
specialization  which  comes  into  our  present  topic  is  that  which 
manifests  itself  within  a  single  industrial  establishment.  In  such 
an  establishment,  when  the  scale  of  production  is  sufficiently  large, 
each  man  or  each  machine  may  take  only  some  very  small  step  in 
the  total  process.  In  a  great  automobile  factory  where  thousands 
of  cars  are  constructed  every  day,  it  is  feasible  to  install  a  machine 
for  stamping  out  a  single,  very  small  standardized  part  of  the  car, 
because  the  number  required  is  so  great  that  the  machine  can  work 
steadily  all  day,  and  probably  all  night  at  that  one  unvarying  task; 
whereas,  in  a  small  factory  such  a  machine  could  be  kept  running 
only  a  few  hours  per  day  and  so,  owing  to  the  expense  of  installa- 
tion and  upkeep,  its  use  would  not  be  feasible.  That  large  scale 
production  makes  possible  this  extreme  application  of  the  policy 
of  specialization  is  thus  one  great  reason  why  it  increases  pro- 
ductive efficiency. 

Economy  in  Factors. — A  second  important  reason  for  the 
connection  between  large  scale  operations  and  productive  efficiency 


96  PRINCIPLES  OF  ECONOMICS  [VII 

is  the  fact  that  large  scale  production  secures  economy  in  the  use  of 
different  factors  or  instruments.  Two  phases  of  this  principle 
should  be  noticed. 

(1)  At  certain  points  specialization  has  to  be  carried  almost 
as  far  in  the  small  concern  as  in  the  large  one;  and  the  large  one 
permits  a  fuller  utilisation   of   the  specialised   factor.     Thus   the 
country  store  at  Four  Corners  is  obliged  to  employ  at  least  one 
clerk,  although  in  the  long  intervals  between  customers  he  spends 
three-fourths. of  his  time  whittling  the  nail  keg;  in  a  city  depart- 
ment store,  in  contrast,  most  clerks  are  continuously  busy  waiting 
on  customers.     A  railroad  company   producing  transportation  be- 
tween New  York  and  Boston  is  obliged  to  lay  and  maintain  at  least 
one  line  of  track  even  if,  owing  to  the  competition  of  other  lines, 
it  runs  only  two  trains  a  day;  but  if  the  road  conducts  a  large 
business,  the  same  single  line  of  track  can  at  a  very  slight  increase 
of  expense  be  utilized ^by  dozens  of  trains. 

(2)  A   second  manifestation   of  the  economy  of   large  scale 
production  is  to  be  found  in  the  fact  that,  while  each  producing 
concern  has  to  keep  in  its  stock  of  raw  materials,  tools,  and  finished 
products  some  reserves  to   meet  contingencies,  the  reserves  of  a 
large  concern  are  sure  to  be  relatively  much  less  extensive  than  those 
of  the  small  concern.     If  there  are  four  haberdasher  stores  in  a 
town  with  an  adult  male  population  of  one  thousand,  each  store  will 
need  in  the  spring  a  stock  of  straw  hats  perhaps  50  or  100  in  excess 
of  its  probable  sales.    A  single  large  store,  replacing  the  small  ones, 
and  with  probable  sales  as  great  as  all  of  them  together,  would  need 
contingency  reserves  but  little  greater  than  any  one  of  the  four. 

Utilizes  Waste  Products. — Again,  large  scale  production 
makes  it  possible  to  utilize  waste  products.  A  familiar  illustration 
is  that  of  the  great  packing  houses  where  various  portions  of  the 
slaughtered  animals,  which  taken  in  small  quantities  would  be 
worthless,  accumulate  to  such  an  extent  that  the  total  has  con- 
siderable value,  and  can  be  used  with  profit.  Where  cotton  is  ginned 
at  a  small  plant,  the  seed  extracted  from  the  fiber  is  thrown  away 
or  destroyed ;  but  large  ginning  concerns  develop  from  the  seed 
important  by-products,  oil  and  meal.  The  total  amount  of  such 


VII]  PRODUCTIVE  EFFICIENCY  97 

economies  effected  by  large  industries  is  enormous,  though  a  small 
plant,  in  attempting  to  utilize  similar  waste,  would  spend  more  than 
it  would  save. 

Bargaining  Power. — Finally,  large  scale  production  insures 
better  bargains  when  a  concern  comes  on  the  market  as  a  buyer  or 
seller.  A  large  concern  can  buy  its  supplies  more  cheaply  than 
a  small  one,  because  the  seller,  under  competition,  is  willing  to 
accept  a  relatively  small  profit  in  order  to  close  the  large  trans- 
action; or,  more  important,  he  can  often  sell  goods  in  large  quanti- 
ties at  a  smaller  rate  without  lowering  the  profit,  because  the 
expenses  connected  with  the  large  sale — the  selling  effort,  the  clerical 
work,  the  packing,  the  transportation — are  relatively  lower  than 
those  connected  with  the  small  sale.  In  selling  its  product,  on  the 
other  hand,  the  large  concern  has  corresponding  advantages  over 
the  small.  Just  because  it  produces  more  efficiently,  it  can  sell  at 
a  lower  price  and  yet  obtain  quite  as  high  a  profit.  And,  by  means 
of  its  superior  selling  force — its  salesmen,  its  advertising,  its  show 
rooms,  and  so  on — it  can  usually  outsell  small  concerns  at  the  same 
level  of  prices. 

Limit  to  Best  Size. — As  a  qualification  upon  all  the  comments 
made  above,  it  should  be  noted  that  industrial  units  have  an  in- 
definite, but  none  the  less  real,  limit  to  the  size  at  which  they  can 
be  effectively  worked.  The  limit  is  high  in  some  industries,  like 
manufacturing,  because  the  restricted  area  covered  by  manufactur- 
ing operations  makes  supervision  of  the  workmen  easy.  It  is  low 
in  other  industries,  such  as  agriculture,  for  the  opposite  reason.  The 
organization  unit,  the  unit  having  a  single  managerial,  clerical,  and 
buying  and  selling  force,  can,  it  often  seems,  be  enlarged  indefinitely; 
but  it  is  in  fact  limited  by  the  organizing  abilities  of  business  men 
in  the  time  and  country  where  the  unit  seeks  to  operate — a  concern 
may  become  so  large  that  the  securing  of  honest  and  efficient  man- 
agement is  well  nigh  impossible.  The  physical  unit  of  production, 
the  plant,  will  of  course  reach  a  size  beyond  which  it  cannot  profit- 
ably be  increased  much  earlier  than  will  the  organization,  or  man- 
agement, unit. 


98  PRINCIPLES  OF  ECONOMICS  [VII 

IV 
Integration  of  Industries 

Meaning. — In  the  preceding  sections  we  have  discussed  the 
conditions  of  productive  efficiency  with  regard  to  which  there  is 
much  confirmatory  experience  and  little  difference  of  opinion.  In 
this  and  the  following  section,  we  meet  two  alleged  methods  of 
increasing  efficiency  which  are  of  more  recent  origin  and,  in  many 
minds,  of  doubtful  value.  One  of  these  methods,  which  has  been 
named  the  integration  of  industries,  consists  in  bringing  together 
under  one  control  many  industries  which,  though  dissimilar,  are 
interdependent.  Thus  the  steel  producer  does  not  confine  himself 
to  the  single  process  of  converting  pig  iron  into  steel.  He  under- 
takes also  to  maintain  a  plant  for  making  pig  iron  from  the  ore, 
and  another  one  for  getting  the  ore  from  the  mine ;  he  may  in 
addition  own  and  operate  coal  mines  and  coke  furnaces  to  obtain 
the  fuel  he  needs ;  and  may  construct  railways  to  transfer  his  various 
completed  or  partly  completed  products  from  one  plant  to  another. 

Advantages. — One  reason  why  this  integration  promotes 
efficiency  is  that  it  enables  the  producer  to  realize  more  fully  the 
gains  natural  to  large  scale  production.  Another  reason  is  that  it 
secures  a  variety  of  economies,  due  to  the  complemental  nature  of  the 
industries  integrated,  particularly  in  that  each  of  these  industries, 
save  the  lowest,  provides  a  market  for  the  product  of  some  other 
member  of  the  series,  and  thus  saves  the  expenses  of  selling  and 
diminishes  the  risk  burden.  The  production  of  steel,  which  fur- 
nished the  first  great  application  of  this  method,  has  been  and  still 
is  eminently  successful ;  and  numerous  other  industries  have  in  late 
years  adopted  a  similar  practice  with  favorable  results. 

V 
Unification  of  Industries 

A  very  characteristic  development  of  industry  during  the  last 
twenty  years,  particularly  in  the  United  States,  is  the  coalescing 


VII]  PRODUCTIVE  EFFICIENCY  99 

of  many  hitherto  independent  industrial  units  of  the  same  kind 
into  a  single  all-inclusive  unit.  Such  units  are  commonly  known 
as  trusts  or  combines.  The  practice  illustrated  in  their  organization 
is  contrasted  with  that  just  described  under  Integration,  in  that 
the  latter  combines  dissimilar,  though  interdependent,  units,  while 
trusts  combine  similar  units.  An  integration  puts  together  coal  mining, 
iron  mining,  pig  iron  making,  and  steel  making.  A  trust  puts  to- 
gether the  American  Steel  Company,  the  Carnegie  Steel  Company, 
and  the  Illinois  Steel  Company. 

Evidently  the  formation  of  a  trust  must  in  most  cases  realize  one 
of  the  conditions  already  considered,  largeness  of  scale  in  produc- 
tion, and  hence  it  must  so  far  tend  to  increase  productive  effi- 
ciency. Thus,  a  combination  bank  which  takes  the  place  of  five 
independent  banks,  will  be  five  times  as  large  as  the  average  of  the 
five,  and  its  efficiency  will  be  much  greater  than  five  times  the  average. 

But,  secondly,  the  combination  unit  will  naturally  have  some 
advantages  not  necessarily  belonging  to  an  original  unit  of  equal 
size,  derived  from  the  very  fact  that  it  is  the  result  of  combination, — 
that  it  has  grown  out  of  a  variety  of  sources.  For  different  ones 
of  the  combining  units  may  have  developed  specially  efficient  methods 
or  machines  which,  hitherto  kept  as  trade  secrets,  will  be  much  more 
fully  utilized  under  the  combination.  In  an  equally  large  unit  which 
was  a  single  unit  from  the  outset,  many  of  these  methods  would 
perhaps  never  have  been  developed. 

Monopoly,  Partial  or  Complete. — A  third  possible  ground  for 
expecting  greater  productive  efficiency  from  the  trust  or  combina- 
tion is  to  be  found  in  the  fact  that  such  a  combination  secures 
partial  or  complete  monopoly  in  the  industry  involved.  This  con- 
dition is  without  doubt  very  objectionable  on  a  variety  of  grounds. 
But  we  are  here  concerned  only  with  its  relation  to  efficiency ;  and, 
while  there  is  room  for  controversy  even  on  this  side  of  the  matter, 
the  consensus  of  informed  opinion  would  seem  to  be  favorable  to 
the  claims  of  the  trust.1  The  chief  ground  on  which  greater  effi- 


1  Perhaps  the  best  proof  of  this  is  the  tendency  of  all  the  great  industrial 
nations  to  favor  the  formation  of  trusts  (syndicates,  cartels)  as  necessary 


100  PRINCIPLES  OF  ECONOMICS  [VII 

ciency  is  claimed  for  monopoly  is  that  it  makes  possible  a  number 
of  economies  which  are  not  possible  under  free  competition. 

Legitimate  Advantages. — (i)  A  big  firm  with  no  competi- 
tion can  diminish  its  advertising,  reduce  its  force  of  salesmen,  and, 
in  general,  cut  down  all  the  expenses  of  marketing  its  product. 
This  is  equivalent  to  saying  that  the  firm  can  produce  its  goods — 
from  raw  material  to  consumption  stage — with  less  effort  and  at 
less  cost,  and  therefore  clearly  means  a  gain  in  efficiency.  (2)  The 
monopoly  can  have  plants  in  all  parts  of  the  country,  and  fill  orders 
from  the  particular  plant  nearest  the  consumer,  thus  minimizing  the 
costs  of  transportion.  (3)  The  monopolist  need  not  seek  to  adjust 
production  to  his  possible  share  of  a  considerable  demand, — a 
quantity  very  difficult  even  to  approximate — he  can  adjust  it  to  the 
whole  demand,  a  quantity  which  can  often  be  ascertained  quite 
exactly.  He  thus  incurs  less  risk  from  loss,  and  in  so  far  as  that  risk 
is  a  cost  of  production  he  is  enabled  to  produce  more  efficiently. 

It  should  be  evident  from  all  the  above  discussion  that  com- 
bination, whether  it  results  in  monopoly  or  not,  belongs,  on  many 
important  grounds,  among  the  conditions  with  which  this  chapter 
is  concerned.  We  are  therefore  probably  justified  in  saying  that, 
generally  speaking,  mere  technical  efficiency  is  usually  increased  by 
the  consolidating  of  like  industries  under  one  control. 

ILLUSTRATIVE  PROBLEMS 

1.  Some  of  the  big  farms  of  East  Prussia  have  their  own  little  rail- 
ways, locomotives,  cars,  etc.    What  advantage  of  large  scale  production 
does  that  illustrate? 

2.  Suppose  that  the  five  banks  of  Ann  Arbor  were  to  be  united  into 
one  and  that,  while  each  of  the  uniting  banks  employs  a  cashier,  a  teller, 
a  bookkeeper,  and  a  messenger,  the  consolidated  bank  were  to  employ  a 
cashier,  a  paying-teller,  a  receiving-teller,  a  discount-clerk,  a  collection- 
clerk,  a  head  bookkeeper,  an  assistant  bookkeeper,  and  a  messenger. 
Show  that  the  facts  as  stated  illustrate  two  gains  of  large  scale  industry. 


to  the  maintenance  of  their  position  in  the  competition  for  the  trade  of  the 
world. 


VII]  PRODUCTIVE  EFFICIENCY  IOI 

3.  "If  the  four  or  five  dry-goods  stores  on  Main  street  were  united, 
a  great  saving  in  the  fund  of  circulating  capital  required  in  that  business 
would  be  effected." 

(a)  Argue  for  the  truth  of  the  quotation. 

(b)  Show  that  the  new  plan  would  probably  effect  a  saving  in  fixed 
capital  also. 

VI 
Industrial  Freedom 

Excessive  Public  Regulation. — The  last  quarter  of  the  eight- 
eenth century  found  most  of  the  western  nations  dominated  by 
governments  which  exercised  a  very  complete  despotism  not  only 
in  respect  to  matters  commonly  regarded  as  well  within  the  scope 
of  political  action,  but  also  in  respect  to  economic  matters.  The 
trade  or  occupation  which  each  individual  might  enter  was  pre- 
scribed from  his  birth;  the  period  to  be  spent  in  apprenticeship, 
learning  the  trade,  was  likewise  already  arranged ;  and,  when  he 
became  a  qualified  workman,  the  amount  and  kind  of  goods  he  might 
produce  and  the  remuneration  he  might  receive  for  them  were  not  de- 
termined by  his  will  or  choice,  but  by  the  law.  Manufacturing 
industries  also  were  regulated  in  the  minutest  way;  the  kind  of 
materials  each  establishment  should  use,  the  amount  of  materials 
it  should  devote  to  each  unit  of  product — for  example,  the  number 
of  threads  in  a  square  yard  of  cloth, — and  the  quantity  of  product 
it  might  finish  in  a  given  time,  were  rigidly  fixed.  And,  to  insure 
observance  of  the  laws,  inspectors  were  always  on  hand  who  exacted 
penalties  with  the  greatest  severity. 

Substitution  of  Freedom. — In  its  beginning  this  excessive 
interference  with  the  spontaneous  course  of  industry  was  probably 
justified;  it  had  the  negative  effect  at  least  of  preventing  labor  and 
labor's  output  from  falling  below  a  certain  standard.  But  there 
early  developed  among  business  men  and  thoughtful  students  a  dis- 
trust of  such  interference.  It  was  not  only  annoying,  they  thought, 
and  inconsistent  with  principles  of  personal  right  and  liberty,  but 
it  actually  hindered  the  attainment  of  the  result  at  which  it  was 


102  PRINCIPLES  OF  ECONOMICS  [VII 

aimed.  Nations  intended  to  make  themselves  efficient  and  rich, 
but  by  the  very  means  employed  for  this  end  they  destroyed  their 
efficiency  and  so  became  poor.  For  various  reasons,  near  the  close 
of  the  eighteenth  century  or  in  the  early  years  of  the  nineteenth, 
the  latter  notion  came  to  be  widely  accepted  and  incorporated  into 
government  policy.  As  a  result  of  this  change,  or  as  a  result  of 
it  in  combination  with  other  forces,  industry  thereafter  advanced 
at  a  quite  unparalleled  pace.  Hence  modern  economists  have  come 
generally  to  hold  the  opinion  that,  whatever  objections  there  may  be 
to  it  on  other  grounds,  industrial  freedom  undoubtedly  contributes 
to  efficiency. 

Better  Guidance. — Freedom  of  trade  we  have  already  dis- 
cussed for  this  viewpoint.  It  widens  the  market  for  each  in- 
dividual's goods,  and  thereby  encourages  that  thoroughgoing  spe- 
cialisation which  contributes  so  greatly  to  industrial  efficiency.  The 
freedom  of  individuals  to  choose  their  own  occupation  and  to 
produce  according  to  self -set  and  market-set  standards,  has  advan- 
tages no  less  important.  In  the  first  place,  it  tends  to  give  industrial 
forces  a  direction  which  will  naturally  result  in  the  greatest  produc- 
tivity, (i)  As  a  rule,  the  individual  himself  is  better  able  than  any 
one  else  to  decide  what  he  is  fitted  to  do,  or  at  any  rate  what  he  can 
do  with  keenest  interest  and  a  good  will ;  hence  in  occupations  freely 
chosen,  both  aptitude  and  interest  will  guide  him  in  the  production  of 
more  and  better  goods.  (2)  By  producing  the  things  for  which  he  is 
best  fitted,  a  man  confers  the  greatest  number  of  utilities  upon 
society  at  large,  for  whom  the  things  are  produced.  But,  conversely, 
when  society  comes  to  obtain  these  things  by  exchange  from  the 
producer,  it  also  confers  the  greatest  number  of  utilities  upon  him. 
Hence,  if  a  man  is  free  to  choose,  he  will  have  not  only  the  motive 
of  workmanship  pleasure,  but  also  that  of  economic  gain,  for  turning 
his  energies  into  the  most  efficiently  productive  channel. 

Greater  Stimulus. — Second,  and  no  less  important,  is  the  fact 
that  under  a  regime  of  freedom  men  are  spurred  on  by  the  stimulus 
of  competition  or  emulation.  That  a  man  has  the  privilege  of  mak- 
ing any  product  for  which  he  discovers  an  aptitude,  and  of  selling 


VII]  PRODUCTIVE  EFFICIENCY  103 

the  product  so  widely  as  to  gain  a  great  profit  if  he  can  make  it  well 
enough, — that  he  may  hope,  on  the  one  hand,  to  gain  almost  anything 
if  he  works  efficiently,  and  that  he  is  in  danger,  on  the  other  hand, 
of  losing  to  others  almost  everything  if  he  does  not  so  work, — these 
are  conditions  which  call  forth  the  most  strenuous  efforts  of  most 
men.  Finally,  there  are  certain  moral  qualities  generally  recognized 
as  requisite  to  good  workmanship — self-reliance,  decision  of  charac- 
ter, energy,  industry,  and  so  on — which  are  naturally  best  developed 
under  conditions  where  the  individual  acts  on  his  own  initiative,  not 
like  an  automaton  under  the  guidance  of  an  outside  power. 

Disadvantages  of  Laissez  Faire. — It  must  be  admitted,  of 
course,  that  the  general  truth  here  set  forth  has,  like  most  others, 
numerous  limitations.  Advocates  of  non-interference  have  always 
recognized  that  some  governmental  oversight  of  industry  is  necessary 
to  secure  the  very  liberty  which  they  wish  to  see  prevail,  since  one 
individual  may  become  so  strong  and  so  ruthless  in  the  use  of  his 
strength  that  he  will  restrict  the  liberty  of  other  individuals.  On 
this  ground,  governmental  action  has  in  our  day  been  extended  very 
far — in  the  control  of  monopolistic  combinations,  for  example — and 
that  with  the  approval  of  most  economic  thinkers.  Further,  ex- 
perience under  the  laissez  faire  regime  has  shown  that  the  industrial 
efficiency  secured  by  some  forms  of  freedom  may  be  purchased  at 
too  high  a  price.  Excessive  labor  of  women  and  children,  physical 
injuries  from  improperly  guarded  machinery,  and  kindred  evils,  have 
called  for  and  secured  much  remedial  legislation.  At  the  present 
time,  there  still  remain  many  abuses  incident  to  great  industrial 
liberty  the  correction  of  which  is  perhaps  more  important  than  the 
high  efficiency  to  be  derived  from  that  liberty.  It  is  probable  therefore 
that  for  some  time  we  shall  see  not  less,  but  more,  governmental 
interference  along  these  lines. 

Positive  Services  of  Government. — In  addition  to  these  purely 
restrictive  forms  of  interference,  there  are  others  of  a  more  positive 
nature  which  a  government  may  sometimes  engage  in  with  results 
undoubtedly  beneficial  to  industry.  By  its  grant  of  franchises,  a 
government  encourages  the  building  of  railroads,  thereby  giving  to 


104  PRINCIPLES  OF  ECONOMICS  [VII 

industry  all  the  benefits  of  easy  transportation — especially  a  wide 
market — and  its  dredging  of  harbors  and  digging  of  canals  contribute 
toward  the  same  end.  In  a  new  field  of  activity  where  there  seems  to 
be  a  lack  of  private  initiative,  the  government  has  investigated  in- 
dustrial methods  and  offered  itself,  more  or  less  informally,  as  an 
instructor.  The  agricultural  experiment  stations  is  an  illustration, 
and  the  free  bulletins  and  weather  reports  supplied  to  farmers. 
There  has  developed  also  in  very  recent  years  a  strong  movement  for 
vocational  direction,  which  aims,  not  to  determine  people's  occupations 
for  them  by  authority,  but,  by  expert  study  of  personal  aptitudes  and 
of  accessible  occupations,  to  help  the  individual  choose  the  work  in 
which  he  will  be  most  successful.  In  all  these  lines,  also,  it  is  probable 
that  the  future  will  bring  rather  an  increase  than  a  diminution  of 
governmental  activity. 

Non-interference  Favorable. — Admitting  all  these  limitations, 
however,  the  statement  that  non-interference  contributes  to  efficiency 
still  holds  good.  The  needed  control  on  the  one  hand,  and  the  patron- 
age or  instruction  on  the  other,  should  be  kept  at  a  minimum,  and 
should  be  carried  out  with  care  and  discretion.  In  general,  industrial 
efficiency  is  greater  under  a  regime  of  freedom,  non-interference, 
laissez  faire,  than  under  one  of  much  governmental  regulation. 


CHAPTER  VIII 
EFFICIENCY  OF  DIFFERENT  FACTORS 

The  preceding  discussion  has  set  forth  the  more  general  principles 
of  productive  efficiency.  It  seems  desirable  in  addition  to  take  up 
separately  the  different  factors  concerned  in  production  and  consider 
the  conditions  of  efficiency  peculiar  to  each.  Let  us  begin,  as  we 
have  in  earlier  analyses,  with  the  labor  factor. 

I 
The  Efficiency  of  Labor 

Since  the  particular  contribution  of  labor  to  productive  processes 
is  the  power  of  force  to  arrange  nature's  materials,  then  labor  will  be 
efficient  in  so  far  as  it  arranges  those  materials  relatively  well.  It 
remains  to  inquire  what  characteristics  will  enable  labor  best  to  exert 
its  force,  and  how  those  characteristics  may  be  secured. 

The  Physical  Side. — The  first  essential  of  the  labor  factor  is 
mere  physical  strength  and  endurance,  the  ability  to  put  forth  a 
relatively  large  amount  of  force  at  any  one  moment,  and  to  continue 
such  exertion  for  an  extended  period  of  time.  The  sources  of  such 
strength  are  fairly  well  known.  They  are  in  part  racial,  evidently, 
since  the  workmen  of  one  race  average  much  higher  in  bulk  and 
brawn  and  physical  power  than  those  of  another  race ;  they  are  in 
part  matters  of  a  narrower  family  inheritance,  since,  of  two  work- 
men of  the  same  blood  strain,  one  may  exhibit  capacities  greatly  in 
excess  of  the  other.  But  with  these  causes  we  are  not  particularly 
concerned  in  the  study  of  economics.  What  we  are  concerned  with 
is  the  fact  that  of  two  men  of  equal  natural  endowment,  one  may 
supply  much  the  greater  force ;  and,  the  reasons  of  this  can  generally 
be  found  in  the  superiority  of  the  food  he  eats,  of  the  house  he  occu- 

105 


106  PRINCIPLES  OF  ECONOMICS  [VIII 

pies,  and  the  generally  sanitary  and  helpful  conditions  under  which  he 
lives.  From  this  it  is  but  one  more  step  to  the  final  answer  of  our 
question.  How  do  men  come  by  the  material  goods  necessary  to 
enable  them  to  lead  the  kind  of  life  most  conducive  to  physical  fitness  ? 
Our  present  economic  order  being  one  of  exchange  cooperation, 
most  goods  are  obtained  through  exchange  from  others.  But,  in  such 
an  order,  the  amount  of  goods  each  man  gets  will  be  affected  by  the 
amount  of  goods  he  himself  produces  and  offers  in  trade,  and,  on 
the  other  hand,  by  the  amount  produced  in  the  group  with  which  he 
exchanges.  Hence,  the  limitation  of  the  goods  that  can  be  enjoyed 
by  each  man  is  set  by  the  productive  efficiency  of  the  group.  Men's 
real  incomes,  and  consequently  their  physical  strength  may,  then,  be 
said  to  depend  on  an  observance  of  the  general  laws  of  productive 
efficiency  set  forth  in  the  last  chapter — capitalistic,  large-scale,  laissez- 
faire  production  and  all  the  rest.  That  this  should  be  true,  from 
a  priori  considerations  is  easy  to  see.  But  it  could  also  be  shown  by 
a  study  of  industrial  history  and  sociology  that  the  living  conditions, 
and  so  the  physical  fitness  of  workmen,  have  uniformly  been  far 
superior  in  those  countries  where  these  laws  of  productive  efficiency 
have  been  observed  than  in  countries  where  they  have  not  been 
observed. 

The  Intellectual  Side. — A  second  characteristic  of  the  labor 
factor  is  mental  power.  Mental  power  is  important  first  as  the 
director  and  the  source  of  skill  for  mere  physical  strength;  if  one 
does  nothing  but  pick  up  sticks  it  is  better  that  he  pick  them  up  in  an 
intelligent  and  clever  manner.  The  need  for  skilled  craftsmanship 
seems  smaller  in  our  day  than  it  formerly  was,  because  the  man  who 
once  made  a  complete  object  with  his  own  hands,  tends  now  to  be 
replaced  by  the  man  who  makes  only  a  very  small  part,  and  that  by 
means  of  machinery.  Nevertheless,  the  skill  that  was  once  needed 
for  the  direction  of  one's  hands  is  now  the  more  needed  for  the  care 
and  tending  of  the  complicated  and  delicate  machines.  But  there  is 
a  further  use  for  mental  strength  in  the  labor  factor.  In  our  analysis 
of  production  we  defined  labor  not  as  physical  force  only,  but  as 
any  and  all  kinds  of  exertion,  including  the  higher  intellectual  forms. 
Exertion  of  the  mind  is  itself  labor.  In  our  present  system  of  large 


VIII]  EFFICIENCY  OF  FACTORS  107 

scale,  highly  capitalized  production,  the  purely  intellectual  exertion 
of  the  promoter,  the  manager,  and  other  agents  is  the  most  important 
labor  of  all.  And  so,  for  such  labor,  there  is  special  need  in  the 
laborer  of  unusual  mental  power. 

Disregarding  natural  gifts,  men  acquire  mental  power  chiefly 
through  the  processes  of  training  or  education.  The  first  prerequisite 
of  such  acquisition  is  the  desire  of  the  individual ;  and  it  often  seems 
that  where  this  desire  is  strongly  present  it  will  carry  one  over  all 
obstacles  to  the  goal.  Of  this  point  we  shall  speak  further  in  a  mo- 
ment. But  for  the  masses  of  mankind,  something  else  is  needed,  a 
something  of  more  concern  in  economic  studies,  because  it  can  be 
provided  by  economic  means.  Perhaps  the  clearest  economic  source 
of  mental  fitness  will  prove  on  examination  to  be  identical  with  that 
of  physical  fitness — productive  efficiency.  For  most  of  us  it  is 
necessary,  first,  that  training  facilities  be  provided,  free  and  accessible, 
if  not  compulsory,  and,  second,  that  the  immediate  problem  of  sus- 
taining life  should  not  press  upon  us  too  hardly,  but  leave  us  leisure 
and  strength  for  self -improvement.  But,  clearly,  these  two  requisites 
will  be  most  fully  met  in  a  state  of  high  productive  efficiency.  A 
country  efficient  in  production  will  be  a  wealthy  country;  and,  other 
things  being  equal,  a  wealthy  country  will  have  more  abundant  means 
of  education,  with  more  opportunity  for  their  enjoyment  by  its 
citizens,  young  and  old. 

Motivation/ — A  third  characteristic  essential  to  the  effective- 
ness of  labor  may  be  broadly  named  as  willingness  or  ambition.  How- 
ever great  man's  natural  endowment  of  body  and  mind,  and  however 
excellent  his  opportunities  for  development,  labor  will  always  be 
ineffective  if  it  lacks  in  the  quality  of  willingness. 

The  willingness  to  work  depends  primarily,  no  doubt,  on  a  general 
attitude  of  mind  which  makes  the  possession  of  economic  goods  worth 
striving  for.  Occasional  individuals  with  a  taste  for  simplicity 
prefer  to  unburden  themselves,  as  they  conceive  it,  of  all  material 
things  except  the  bare  necessities  of  life;  and,  if  in  addition  they 
are  preoccupied  with  some  idealistic  pursuit,  they  will  naturally  show 
little  inclination  to  perform  economic  labor.  Likewise  certain  oriental 
peoples  and  religious  sects  regard  serenity  of  mind  and  contemplation 


I0g  PRINCIPLES  OF  ECONOMICS  [VIII 

as  more  to  be  desired  than  any  amount  of  material  wealth.  Among 
western  peoples,  however,  a  natural  taste  for  economic  goods  seems 
all  but  universal.  So  far  as  willingness  to  work  depends  on  a  desire 
for  the  fruits  of  work,  they  are  willing  enough. 

The  next  requisite  for  willingness  or  ambition  is  the  availability 
of  goods  worth  buying.  A  frontier  settler,  or  a  peasant  in  the  in- 
terior of  China,  however  keen  his  craving  for  enjoyable  goods,  will 
not  greatly  exert  himself;  he  will  raise  only  what  he  can  consume 
and  will  in  general  tend  to  become  a  shiftless  no-account,  unless  the 
products  of  more  civilized  communities  are  within  buying  distance. 
But  the  only  stimulus  needed  for  these  peoples  is  productive  efficiency 
in  their  neighbors,  and  improvement  in  the  means  of  transportation 
and  exchange.  Thus  certain  eastern  countries  have  even  in  this  gen- 
eration become  keen,  active  producers,  mainly  because  western  na- 
tions brought  to  their  doors  commodities  which  they  wanted,  but 
which  they  could  not  have  unless  they  produced,  for  exchange,  some- 
thing wanted  by  the  western  nations. 

Given  a  natural  taste  for  material  goods,  and  a  stimulation  of  that 
taste  by  the  presence  of  such  goods,  there  is  still  often  something 
wanting  to  induce  willingness  to  work.  That  something  is  an  as- 
surance that,  having  worked,  one  will  be  allowed  to  consume  a  quan- 
tity of  goods  proportionate  to  the  effort  put  forth.  In  other  words 
there  must,  ordinarily,  be  some  guarantee  of  the  reward.  Now,  in 
the  existing  economic  order,  the  amount  of  a  man's  reward  is  for  the 
most  part  determined  automatically  by  the  process  known  as  distri- 
bution. Whether  his  reward,  as  so  determined,  is  proportionate  to 
the  effort  put  forth,  may  therefore  much  better  be  reserved  for  a 
later  part  of  our  study.  In  some  part,  however,  the  assurance  of 
one's  reward  has  its  source  quite  outside  the  realm  of  Economics 
proper.  It  springs  from  a  general  confidence  in  the  moral  integrity 
of  the  community  where  one  lives  and  with  which  one  maintains 
business  relations.  One  must  know  that  his  neighbors  are  not  going 
to  steal  his  goods,  whether  restrained  by  their  sense  of  right  or  by 
the  policing  activities  of  government.  One  must  knew  that  the 
government  itself  will  not  confiscate  his  property  or  drain  him  dry 
by  exorbitant  taxes,  and  that  the  government  is  able  to  defend  him 
from  invasion  and  robbery  by  foreign  foes. 


VIII]  EFFICIENCY  OF  FACTORS  109 

II 
The  Efficiency  of  Land 

The  land  factor 'in  production  furnishes  man  with  position  on  the 
earth's  surface,  with  primary  raw  materials,  and  with  natural  powers. 
The  question  of  land-effectiveness  in  its  simplest  form  is  merely, 
"How  can  nature  supply  man  with  most  materials  of  the  best  sort  ?" 
So  far  as  nature's  own  part  is  concerned,  the  question  is  easily 
answered — she  can  supply  most  by  being  rich,  fertile,  plentiful.  But 
nature  is  passive,  what  she  supplies  is  supplied  once  for  all,  or  in  a 
blind  and  purposeless  way,  so  her  "activities,"  if  such  may  be  called 
her  mere  existence,  are  hardly  a  matter  for  discussion.  But  from 
man's  viewpoint  there  is  much  to  be  said.  How  can  man  realize  the 
greatest  amount  of  utilities  from  the  existing  natural  supply? 

Advantages  of  Private  Ownership. — Any  given  individual  can 
do  best  for  himself  with  nature's  materials  if  he  is  free  to  command 
all  he  wants  at  any  time  he  wants  them.  Nature's  materials  are  most 
efficient  for  me  if  I  can,  whenever  the  need  arises,  go  out  and  cut 
down  timber,  dig  ore,  or  plant  grain  on  any  selected  piece  of  ground. 
But  the  viewpoint  of  particular  individuals  is  not  important  here. 
Considered  absolutely,  land  is  most  efficient  when  it  is  available  for 
that  man,  among  all  men,  who  is  qualified  to  derive  from  it  the 
greatest  product.  There  are  several  ways  in  which  this  fortunate 
availability  might  be  secured.  For  example,  a  communistic  form  of 
government  might  parcel  out  various  portions  of  the  existing  supply 
to  individuals  adjudged  most  competent.  Another  possible  method 
is  for  free  competition  to  determine  who  can  produce  most  from 
each  portion  and  then  for  a  system  of  private  ownership  to  reserve 
for  that  individual  the  exclusive  use  of  the  portion,  free  from  the 
interference  of  others.  The  latter  method  is  the  one  generally  pre- 
vailing at  present ;  it  results  in  a  high  degree  of  land-efficiency,  and 
as  such  will  doubtless  be  preserved  until  one  unmistakably  better  is 
found. 

A  system  of  free  competition,  private  ownership  and  exclusive 
use  can,  however,  be  modified  somewhat,  and  the  land-efficiency 


IIO  PRINCIPLES  OF  ECONOMICS  [VIII 

thereby  be  enhanced.  The  condition  of  free  availability  for  the  most 
competent  needs  definition.  Under  some  circumstances,  land  is  most 
efficient  if  it  yields  all  its  materials  at  once  and  is  thenceforth  ex- 
hausted. A  forest  is  most  efficient  for  the  pioneer  and  for  all  who 
will  follow  him,  if  he  utterly  destroys  a  large  part  of  it  to  use  for 
fences  and  firewood,  and  puts  the  denuded  land  under  cultivation  in 
small  grain.  But,  generally,  it  is  best  that  the  large  trees  only  be 
taken  from  a  forest,  while  the  younger  ones  are  left  to  finish  their 
growth,  and  to  sow  the  seed  of  still  other  trees  to  follow  them.  In 
other  words,  nature  will  make  the  greatest  contribution  to  productive 
processes  in  the  long  run  under  a  policy  of  conservation.  She  will  be 
most  efficient  through  the  years  if  she  yields  at  no  one  time  enough 
to  diminish  her  future  yield.  But  men,  working  under  conditions  of 
private  ownership,  cannot  always  be  trusted  to  persevere  in  such  a 
policy.  Where  individual  wisdom  and  self-restraint  are  insufficient, 
therefore,  the  interference  of  government  to  advise,  and  even  to 
enforce,  conservation  will  contribute  greatly  to  the  productive  ef- 
ficiency of  land. 

Ill 
The  Efficiency  of  Capital 

A  very  little  reflection  will  make  clear  that  efficiency  on  the  side 
of  capital  is  conditioned  chiefly  by  three  things :  an  abundant  stock, 
availability,  and  wise  employment.  The  last  of  these  depends  mostly 
on  the  skill  and  capacity  of  the  entrepreneur  who  determines  what 
shall  be  produced,  and  so  determines  to  what  use  capital  shall  be  put. 
Accordingly,  we  are  here  concerned  principally  with  the  conditions 
which  insure  an  abundant  stock  of  capital,  and  which  insure  that  the 
existing  stock  shall  possess  a  high  degree  of  availability. 

Abundance  of  Capital. — In  dealing  with  the  abundance  of 
capital,  the  first  problem  which  meets  us  concerns  the  origin  of  cap- 
ital. By  what  processes  does  it  come  into  existence?  The  answer  to 
this  has  already  been  in  some  measure  anticipated,  but  a  fuller  state- 
ment is  needed. 


VIII]  EFFICIENCY  OF  FACTORS  III 

Origin  of  Capital. — The  reserve  stocks  of  products  of  any 
community,  its  capital  goods,  have  to  be  brought  into  existence  in 
exactly  the  same  way  as  consumption  products,  that  is,  through  con- 
sciously directed  labor  assisted  by  land  and  previously  accumulated 
capital.  Just  as  certain  factories  are  engaged  in  making  hats,  golf 
balls,  candy,  and  other  consumption  goods,  so  certain  factories  are 
engaged  in  making  engines,  machines,  tools,  and  other  capital  goods. 
At  first  sight,  then,  it  might  seem  as  if  such  a  factory  were  the  place 
to  study  the  question:  "How  does  capital  come  into  existence?"  In 
fact,  however,  we  are  here  interested  in  something  deeper  than  mere 
technical  production.  We  are  looking  for  the  ultimate  origin  of 
capital,  the  moral  origin,  so  to  speak.  This  is  a  legitimate  question  to 
ask  with  reference  to  any  product ;  for,  under  an  exchanging  economic 
order,  the  technical  producer  of  anything,  whether  it  be  an  engine  or 
a  pound  of  candy,  is  not,  in  the  most  ultimate  sense,  responsible  for 
its  existence.  He  produces  that  engine  or  candy  because  he  knows  or 
expects  that  other  people  will  buy  it  from  him.  He  is  in  effect,  there- 
fore, acting  as  the  agent  of  those  people.  This  is  evident  enough  in 
production  to  order;  but  production  for  a  general  market  is  not 
essentially  different,  for  it  is  possible  only  because  experience  has 
shown  that  it  will  work  substantially  the  same  as  if  production  were 
to  order. 

Accordingly,  if  we  wish  to  know  the  ultimate  origin  of  capital, 
we  must  go  to  the  principal  rather  than  to  the  agent.  The  ownership 
of  engines  or  other  capital  goods  means  the  tying  up  of  large  amounts 
of  value  so  that  for  an  extended  period  they  will  yield  income — 
service — to  the  owner  only  at  intervals  and  in  small  amounts.  Not 
everyone,  therefore,  can  afford  to  buy  and  own  such  goods.  How 
does  the  actual  buyer  of  capital  goods  attain  his  ability  to  buy?  In 
case  the  buyer  is  an  entrepreneur  merely,  he  largely  borrows  money 
to  make  the  purchase,  so  that  a  further  inquiry  is  necessary.  How 
does  the  man  who  lends  money  to  the  borrowing  entrepreneur  reach 
a  position  where  he  can  give  up,  say,  $3,000  in  cash  in  exchange  for 
a  yearly  income  of  $150?  The  answer  is  plain.  He  must  have 
accumulated  a  money  fund  which  promised  to  be  for  a  shorter  or 
longer  period  superfluous,  which  was  not  needed  for  any  pressing  uses 
in  the  present. 


112  PRINCIPLES  OF  ECONOMICS  [VIII 

Capital  Comes  from  Saving. — The  accumulation  of  such  a 
fund  obviously  requires  in  the  first  place  that  the  persons  performing 
the  task  shall  get  an  income  from  which  the  accumulation  may  be 
made.  That  is,  he  or  some  factor  belonging  to  him  must  produce 
wealth.  But  this  in  itself,  remember,  would  not  make  him  a  capitalist. 
The  same  necessity  would  be  present  if  the  person  in  question  wanted 
an  equal  amount  of  wealth  to  use  in  giving  a  fire-works,  exhibition. 
His  distinctive  task  as  a  capitalist  lies  beyond  this, — begins  after  the 
wealth  has  been  provided.  Out  of  that  wealth,  it  is  his  business  to 
accumulate  a  fund,  to  be  kept  intact  for  an  indefinite  period,  though 
all  the  while  yielding  a  small  annual  income.  But  this  task  can  be 
accomplished  only  in  one  way:  the  prospective  capitalist  must  save, 
must  practice  abstinence,  must  give  up  getting  directly  any  gratifica- 
tion from  this  portion  of  his  wealth.  Looked  at  as  a  man  who  has 
by  his  sacrifices  put  himself  into  possession  of,  say,  ten  thousand 
dollars,  he  is  merely  a  producer  of  -wealth.  On  the  other  hand, 
looked  at  as  a  man  who  has  given  up  the  privilege  of  using  for  the 
satisfying  of  his  wants,  say,  five  thousand  dollars  out  of  this  total, 
he  is  a  producer  of  capital. 

At  this  point,  however,  a  word  of  caution  is  needed.  The  state- 
ment that  capital  can  be  accumulated  only  by  saving  should  not  be 
interpreted  as  meaning  that,  in  producing  capital,  one  necessarily 
experiences  some  deprivation.  To  a  very  large  extent,  the  capital 
of  the  community  is  accumulated  by  persons  of  whom  this  could  not 
be  said : — to  them  saving  is  often  easier  than  would  be  consuming  the 
immediate  products  on  which  their  savings  might  be  expended.  But 
this  in  no  degree  changes  the  real  nature  of  the  process.  The  fact 
remains  that  the  person  who  produces  capital,  instead  of  using  the 
five  thousand  dollars  of  our  illustration  for  gratifications,  devotes 
them  to  the  building  of  a  fund  permanently  in  reserve,  a  mere 
income-bearer. 

Another  point  should  be  noted  here — that  the  person  who  by  his 
saving  is  building  up  capital  may  or  may  not  retain  his  savings  for 
long  as  a  distinct  money  fund.  He  cannot  "spend"  them,  in  the 
popular  sense  of  the  word,  that  is,  pay  them  out  for  consumption 
goods  such  as  food,  clothing,  excursions,  and  the  like,  which  go 
directly  and  exclusively  to  the  satisfying  of  present  wants.  But  he 


VIII]  EFFICIENCY  OF  FACTORS  113 

can  part  with  the  money  in  exchange  for  engines,  houses,  or  other 
income-bearing  property;  since,  in  doing  that,  he  merely  invests  the 
money,  and  has  in  reality  as  large  a  sum  of  wealth  as  ever.  This  is 
a  distinction  familiar  to  the  business  world ;  but  it  is  frequently  over- 
looked and  so  becomes  the  source  of  a  popular  fallacy  about  money.2 
Bearing  these  distinctions  in  mind,  the  act  or  process  of  saving 
can  have  no  deeper  analysis.  It  is  just  saving,  going  without 
some  gratification  in  the  present  which  one  might  enjoy  if  he 
chose.  The  capitalist  receives  a  money  income ;  he  spends  part  of  it 
consumptively,  but  refrains  from  spending  the  rest — holding  it  as 
money  or  investing  it ;  in  consequence,  he  accumulates  a  fund  with 
which  he  himself,  or  some  one  else  to  whom  he  lends  it,  can  buy 
engines  or  other  productive  goods.  As  economic  society  is  at 
present  constituted,  this  is  substantially  the  only  process  in  which 
capital  grows :  get  an  income;  save  from  that  income.  But,  since 
the  existence  of  an  income  is  implied  in  the  saving  from  it,  we  may 
cover  the  whole  problem  in  a  single  statement :  Under  the  existing 
economic  order  capital  originates  chiefly  in  saving  or  abstinence. 

ILLUSTRATIVE  PROBLEMS 

i.  Suppose  that  a  community  of  say  50,000  persons  living  on  an 
island,  completely  isolated  from  all  other  communities,  but  otherwise  liv- 
ing under  an  economic  system  like  ours,  with  division  of  labor,  trade, 
metallic  money,  etc.,  should  attempt  to  increase  its  capital  by  issuing 
$100,000  of  paper  money. 


a  Before  leaving  this  point,  a  word  of  caution  ought  to  be  added.  In 
insisting  that  capital  has  its  origin  in  saving,  we  must  not  forget  what  has 
been  brought  out  in  another  connection,  that  the  supplying  of  capital  involves, 
not  merely  the  accumulating  of  a  fund  of  money  or  credit,  but  also  the 
actual,  mechanical  producing  of  the  concrete  or  goods  capital — the  engines, 
cars,  machines,  etc.  We  cannot  furnish  power  or  carry  ore  or  make  nails 
with  stores  of  money, — we  must  have  real  engines  and  cars  and  machines. 
Nevertheless,  this  way  of  looking  at  the  matter,  which  fits  the  needs  of 
technical  production,  gives  us  no  light  on  the  origin  of  capital.  The  technical 
making  of  any  particular  piece  of  capital  does  not  originate  that  capital. 
As  remarked  above,  the  man  who  is  really  responsible  for  the  existence  of 
the  capital  is  the  one  who  accumulates  the  fund  of  money;  and  the  conditions 
which  he  has  to  fulfil  in  accomplishing  this  disclose  the  fundamental  nature 
of  the  process  whereby  capital  comes  into  existence. 


H4  PRINCIPLES  OF  ECONOMICS  [VIII 

(a)  Argue  for  the  contention  that,  in  general,  we  should  expect  this 
attempt  to  fail. 

(b)  Try  to  find  some  reasons  for  thinking  that  the  scheme  might 
realize  a  small  measure  of  success.     (Would  said  scheme  tend  to  increase 
the  total  output  of  labor  services?     Would  it  tend  to  release  any  labor 
hitherto  devoted  to  the  old  tasks?) 

(c)  Change  the  hypothesis  by  supposing  the  given  community  to  be 
in  free  trade  relations  with  many  other  communities,  and  argue  that  the 
proposed  issue  would  really  increase  the  capital  of  the  community. 

2.  "When  the  primitive  fisherman  refrains  from  eating  fish  in  order 
to  accumulate  a  store  to  be  eaten  while  he  makes  a  net,  we  obviously  have 
a  case  of  real  saving.     But  when  a  capitalist  keeps  his  money  rather  than 
spending  it,  things  are  very  different.     The  good  things  our  capitalist 
refrains  from  consuming  have  not  been  made  at  all ;  instead,  producers, 
knowing  that  capital  is  being  accumulated,  are  making  engines,  cars,  etc., 
which  obviously  could  not  be  consumed.     But;  if  they  could  not  be  con- 
sumed, they  could  not  be  saved.     Such  capital,  therefore,  does  not  result 
from  saving." 

Taking  as  your  definition  of  saving  this:  "Saving  is  going  without 
something  one  might  otherwise  enjoy,"  show  that  the  capitalist  who 
accumulates  a  fund  of  money  does  really  save. 

3.  Suppose  that,  instead  of  proceeding  as  at  present,  the  capitalist 
were  himself  to  make  the  concrete  pieces  of  capital,  hoes,  plows,  planes, 
engines,  etc.,  and  then  lend  these  to  producers  for  hire.     Would  such 
making  of  capital  involve  saving? 

4.  Suppose  that  a  communistic  state,  in  order  to  increase  its  stock  of 
capital,  should  proceed  to  require  from  every  citizen  one  more  hour  of 
labor  daily.     Would  this  way  of  building  capital  involve  saving? 

We  have  seen  that  capital  comes  into  existence  chiefly  through 
saving,  abstinence — a  deliberate  relinquishment  of  the  present  disposal 
of  income.  What  conditions  favor  the  practice  of  this  line  of 
conduct  ? 

Large  Incomes  Favor  Capital  Accumulation. — One  condition 
certainly  would  seem  to  be  the  existence  of  large  incomes.  It  is  very 
hard  for  people  of  small  incomes  to  save  anything,  and  hard  for  those 
with  moderate  incomes  to  save  much ;  all  they  can  get  together  is 


VIII]  EFFICIENCY  OF  FACTORS  115 

urgently  required  for  their  immediate  wants.  People  with  large 
incomes,  on  the  contrary,  are  able  to  save  with  ease,  simply  because 
there  remains  a  considerable  surplus  after  their  immediate,  pressing 
wants  have  been  satisfied.  But  what  conditions  are  favorable  to  the 
existence  of  large  incomes?  Doubtless  the  most  essential  condition 
is  the  one  we  are  discussing,  namely,  high  productive  efficiency.  The 
man  who  produces  by  ineffective  methods  will  naturally  have  but  a 
small  product,  and  hence  will  need  to  consume  most  of  it  for  each 
day's  sustenance.  The  primitive  fisherman,  equipped  only  with  his 
pair  of  hands,  commanded  a  very  small  income  of  fish ;  and  so  it  was 
only  with  the  greatest  difficulty  that,  while  feeding  himself  today,  he 
could  save  anything  for  tomorrow.  But,  once  possessed  of  a  canoe 
and  "a  net,  the  capitalistic  method  of  fishing  enabled  him  to  catch  in 
a  day  far  more  than  the  day  required,  and  hence  to  save  from  it  much 
and  easily. 

Assured  Gains. — A  second  condition,  or  set  of  conditions, 
favorable  to  saving  is  one  which  insures  to  capital  the  expected  ad- 
vantage of  saving.  As  in  the  case  of  labor,  the  first  assurance  of  an 
appropriate  reward  must  spring  from  the  existing  system  of  distribu- 
tion. But  there  are  other  sources.  A  man  will  have  more  inclination 
to  save  under  a  strong  and  beneficent  government,  where  he  feels 
confident  his  accumulations  will  not  be  taken  from  him  by  theft, 
invasion,  or  extortion.  He  will  save  most,  too,  in  a  flourishing 
country,  where  the  industries  have  become  highly  capitalistic,  so 
that  every  smallest  addition  to  his  surplus  can  readily  find  a  use, 
and  that  at  a  rate  of  interest  fairly  high. 

Good  Banking  Institutions. — A  third  condition  inciting  men 
to  abstinence  is  the  existence  of  social  machinery  suitable  to  aid  in 
caring  for,  and  investing,  their  accumulations.  A  public  banking 
institution  with  burglar  and  fire-proof  vaults  conduces  to  saving, 
because  one  can  intrust  his  accumulations  to  this,  and  be  relieved  of 
all  anxiety  as  to  their  safety.  Banks,  also,  offer  strong  inducements 
of  another  kind,  in  that  they  find  for  the  capitalist  an  opportunity  to 
invest.  An  ordinary  producer  knows  well  enough  how  to  practice 
abstinence — he  can  save  his  hundred  dollars,  or  his  dollar,  or  his  dime 


Il6  PRINCIPLES  OF  ECONOMICS  [VIII 

a  day;  but  in  a  complex  industrial  society  like  ours  he  is  usually 
helpless  about  turning  it  to  use.  He  sees  no  business  near  at  hand 
requiring  his  savings,  and  he  cannot  set  out  to  seek  one  that  does. 
Even  if  he  found  one,  he  would  have  no  capacity  for  judging  of  its 
soundness.  Furthermore,  his  savings  may  be  very  small,  and  such 
sums  as  he  could  offer  would  be  so  inadequate  that  no  business  man 
would  bother  to  accept  them.  A  bank,  on  the  contrary,  is  a  careful 
student  of  business  enterprises,  and  an  expert  judge  of  their  sound- 
ness, so  it  can  take  off  the  saver's  hands  all  the  trouble  of  finding  an 
investment.  And,  finally,  since  it  can  merge  his  small  savings  with 
many  other  small  ones,3  it  can  quite  readily  put  them  to  use,  and  so 
still  further  encourage  him  to  save. 

A  fairly  adequate  general  answer  to  our  question  can  be  put  in  a 
single  sentence:  The  accumulation  of  capital  is  favored  by  the  ex- 
istence of  large  incomes,  by  conditions  which  insure  to  capital  the 
expected  advantages  of  saving,  and  by  the  presence  of  suitable  social 
machinery  to  aid  in  caring  for  and  investing  accumulations. 

ILLUSTRATIVE  PROBLEMS 

1.  Give  reasons  for  expecting  capital  to  accumulate  more  rapidly 
in  England  than  in  Scotland,  in  Germany  than  in  Persia. 

2.  Suppose  the  total  income  of  industry  in  the  United  States  were 
divided  equally  among  all  the  citizens,  do  you  think  capital  would  grow 
as  rapidly  as  it  now  does?    Why? 

3.  Explain  why  postal  savings  banks  would  be  expected  to  increase 
the  accumulation  of  capital ;  same  for  loan  and  trust  companies ;  same  for 
insurance  companies. 

4.  From  our  present  standpoint,  argue  for  or  against  the  system  of 
guaranteeing  bank  deposits. 

High  Availability  of  Capital. — We  have  examined  the  first 
requisite  of  efficiency  on  the  part  of  capital — an  abundant  supply. 
A  final  question  remains:  How,  after  capital  has  been  abundantly 

8  A  bank,  of  course,  utilizes  not  only  the  funds  which  people  have 
definitely  set  apart  to  play  the  role  of  capital,  but  also  a  great  amount  of 
wealth  which  is  only  momentarily  idle. 


VIII]  EFFICIENCY  OF  FACTORS  117 

saved,  can  it  be  made  available  for  those  who  need  and  are  competent 
to  use  it  ? 

When  a  man  himself  uses  the  capital  which  he  saves,  this  question 
has  no  pertinence.  But,  in  modern  industry,  capital  is  generally 
saved  by  one  set  of  men  and  used  by  another.  Availability  therefore 
turns  upon  how  the  two  parties  can  get  together,  how  lending  can  be 
made  easy  on  the  one  side  and  borrowing  on  the  other.  The  first 
part  of  this  question  has  already  been  answered:  lending  is  made 
easy  by  the  existence  of  institutions  which  specialize  in  that  type  of 
work.  But  borrowing  is  made  easy  in  precisely  the  same  way. 
Where  good  banking  institutions  exist  the  business  man  desiring 
capital  knows  at  any  moment  where  a  fund  lies  waiting  for  invest- 
ment ;  and  so  he  can  present  his  demand  at  this  single  place,  instead 
of  hunting  out  the  individual  capitalist — or  perhaps  many  small  cap- 
italists. He  is  also  spared  the  trouble  of  proving  his  soundness  to 
each  small  holder — many  of  whom  are  anyway  unable  to  judge — 
and  furnishing  security  to  satisfy  them.  He  can  prove  his  soundness 
once  for  all  before  men  well  qualified  to  judge,  and  obtain  the  whole 
sum  desired  without  further  difficulty. 

As  under  the  preceding  head,  the  general  conditions  for  rendering 
capital  available  can  be  put  in  a  single  sentence :  The  availability  of 
modern  capital  depends  on  a  high  state  of  entrepreneur  credit  and 
high  efficiency  in  the  institutions  which  deal  in  money  capital — 
banks,  trust  companies,  and  so  on. 

ILLUSTRATIVE  PROBLEMS 

1.  For  some  years  before  and  after  1892,  it  looked  to  European  ob- 
servers as  if  the  United  States  were  likely  to  give  up  the  gold  standard 
and  adopt  silver,  thus  reducing  the  value  of  the  dollar,  as  most  expected, 
by  about  forty  per  cent.     What  effect  would  you  expect  this  condition  to 
have  on  foreign  capital  in  the  United  States? 

2.  The  existence  of  the  ordinary  commercial  bank  enables  us  to 
make  available  quantities  of  money  capital  out  of  funds  which  are  not 
really  set  aside  for  use  as  capital,  but  rather  are  being  kept  for  daily  use. 
Try  to  explain  how  that  can  be.     (Suppose  that  500  persons  kept  the 
funds  which  they  expect  to  put  to  everyday  use  in  a  bank,  and  made 
payments  partly  by  cash  drawn  out,  partly  by  checks  drawn  in  favor  of 


ng  PRINCIPLES  OF  ECONOMICS  [VIII 

one  another.     Show  that  the  bank  could  safely  treat  a  considerable  part 
of  the  funds  as  if  they  were  going  to  be  permanently  idle.) 

3.  In  Germany  there  are  many  agricultural  loan  associations  which 
issue  jointly  guaranteed  bonds  to  the  lending  public,  then  lend  to  their 
members  on  ordinary  mortgage  security.  Does  it  seem  likely  that  this 
system  would  tend  to  make  capital  more  available  to  farmers  ? 

IV 
Efficiency  in  Respect  to  the  Entrepreneur  Function 

As  has  already  been  made  clear,  the  central  function  in  all  pro- 
duction is  that  of  the  entrepreneur,  the  person,  natural  or  legal,  who 
undertakes  any  particular  business, — assumes  the  responsibility  of 
bringing  it  into  existence,  or,  anyhow,  of  continuing  it.  This  of 
necessity  requires  that  he  shall  carry  the  major  part  of  the  risk  in- 
volved and  that  he  shall  himself  perform  certain  fundamental  mana- 
gerial duties.  What  conditions,  now,  are  necessary  to  enable  entre- 
preneurs to  serve  efficiently  in  these  functions? 

There  are  three  chief  requisites  of  efficient  enterprising,  (i)  an 
adequate  supply  of  land,  labor,  and  capital,  (2)  judgment  and  fore- 
sight in  recognizing  opportunities  for  business  undertakings,  and 
(3)  a  spirit  of  enterprise,  or  initiative, — readiness  to  assume  the  re- 
sponsibilities of  production  when  an  opportunity  is  recognized.  The 
first  item  calls  for  little  comment.  Since  the  entrepreneur  achieves 
all  his  results  in  production  by  using  the  other  factors,  his  efficiency 
will  naturally  depend  on  having  them  to  use ;  but  all  questions  relating 
to  the  supply  of  other  factors  are  well  enough  treated  in  the  pages 
immediately  foregoing.  The  second  and  third  requisites  are  perhaps 
also  self-explanatory;  but  the  conditions  which  foster  them  in  a  com- 
munity are,  owing  to  the  central  position  and  the  signal  importance 
of  the  entrepreneur  function,  worth  a  moment's  examination. 

Education. — The  qualities  of  judgment  and  foresight  in  recog- 
nizing good  opportunities  are  in  great  measure  matters  of  natural 
endowment.  They  exist  apparently  in  some  men  and  some  races, 
and  in  other  men  and  races  they  are  absent.  On  the  other  hand,  they 
are  to  some  extent  capable  of  being  taught ;  and,  to  that  extent,  those 


VIII J  EFFICIENCY  OF  FACTORS  119 

countries  will  have  the  greatest  fund  of  entrepreneur  power  which 
employ  the  best  methods  of  teaching  it.  A  community  successful  in 
business  and  largely  given  up  to  business  activities  and  ideals  will 
unconsciously  educate  itself.  By  example,  on  the  one  side,  and 
imitation,  on  the  other,  it  will  inevitably  disseminate  knowledge  to  all 
classes  of  people,  and  pass  down  a  gradually  accumulating  store  from 
generation  to  generation.  But  further,  business  can  be,  and,  as 
thinkers  are  beginning  to  realize,  should  be,  made  a  subject  of  formal 
study.  Recent  years  have  brought  an  enormous  development  in  this 
line:  the  conditions  underlying  and  surrounding  business  successes 
are  analyzed,  statistics  are  compiled  and  weighed,  and  the  general 
principles  of  economics  are  used  in  the  solution  of  practical  business 
problems.  Facilities  have  also  been  created  for  supplying  this  scien- 
tific information  methodically  to  anyone  who  wishes  to  obtain  it. 
The  output  of  business  books  has  been  a  striking  phenomenon  of  the 
last  decade,  while  colleges  have  grown  up  which  teach  not  only  the 
broader  economic  principles  upon  which  business  is  based,  but  also 
the  very  details  of  business  method.  It  is  not  unreasonable  to  expect 
that  by  these  means  the  ability  of  men  in  general  to  recognize  and 
estimate  good  opportunities  will  be  markedly  increased — in  other 
words,  that  the  entrepreneur  function  in  production  will  be  made 
more  efficient. 

Initiative. — The  third  quality  essential  in  entrepreneurs  was 
described  as  enterprise,  initiative,  or  readiness  to  assume  the  responsi- 
bilities of  production.  If  a  country  fails  to  develop  men  of  the 
peculiarly  adventurous  type  who  are  willing  to  assume  the  responsi- 
bilities of  production,  the  entrepreneur  function  in  that  country  will 
be  very  poorly  performed.  In  consequence,  since  the  cooperation  of 
all  other  factors  depends  on  the  entrepreneur,  the  country  may  have 
abundant  natural  resources,  labor  power,  and  capital,  but  until  men 
appear — perhaps  coming  in  from  other  countries — who  dare  to  at- 
tempt great  combinations  of  these  factors,  industry  will  remain  at  a 
standstill. 

Limited  Liability/ — The  enterprising  spirit,  like  good  judg- 
ment, may  in  part  be  attributed  to  natural  endowment — western  races 


120  PRINCIPLES  OF  ECONOMICS  [VIII 

are,  or,  until  the  recent  rise  of  the  Japanese,  were  assumed  to  be, 
more  enterprising  than  eastern.  But  probably  in  greater  part  this 
quality  depends  upon  external  fostering  conditions.  Thus,  something 
less  than  a  century  back,  the  unlimited-liability  partnership  form  of 
cooperative  undertaking  was  much  the  most  common.  Under  this 
form,  a  man  starting  a  new  enterprise  which  might,  for  all  he  knew, 
result  in  failure,  stood  to  lose  all  he  owned.  At  the  present  time,  the 
form  of  organization  more  commonly  used  is  one  possessing  the 
characteristic  of  limited  liability :  the  members  are  responsible  for  the 
debts  of  the  organization,  not  to  the  full  amount  of  their  property, 
but  only  to  a  strictly  defined  sum — the  sum  they  have  put  into  the 
business,  or  perhaps  that  and  as  much  more.  Naturally,  under  the 
latter  conditions,  more  than  under  the  former,  men  will  be  ready 
to  venture  upon  new  and  dangerous  enterprises. 

Again,  where  the  risk  of  undertaking  enterprises  is  great,  men 
must  have  some  assurance  that  in  case  of  success  their  gains  will  be 
correspondingly  great.  The  patent  laws  must  be  effective,  so  that 
when  a  man  launches  on  the  market  an  untried  article  he  will  not  be 
robbed  of  his  unusual  gains  by  others  who  manufacture  the  same 
article  as  soon  as  the  dangers  have  been  overcome.  A  man  must 
know  also  that  his  property  will  not  be  destroyed  or  stolen  by  people 
whom  the  government  cannot  control,  and  that  his  profits  will  not 
be  taken  from  him  through  merciless  taxation  imposed  by  the  gov- 
ernment itself.  Finally,  the  spirit  of  enterprise  is  certain  to  assert 
itself  more  freely  where  some  kind  of  machinery,  legal  and  indus- 
trial, exists  to  help  it.  Thus,  in  earlier  times,  corporations  came  into 
existence  only  by  a  special  act  of  the  legislature ;  in  our  day  they 
are  formed  much  more  readily  by  administrative  process  under  the 
authority  of  a  general  law.  Every  large  city  has  also  nowadays  a 
stock  exchange  where  the  shares  of  corporations  are  daily  bought  and 
sold,  thus  reducing  the  task  of  acquiring  control  of  an  enterprise  to  a 
simple  market  transaction. 

The  conclusions  of  all  this  part  of  our  discussion  may  now  be 
summarized  as  follows :  High  productive  efficiency  in  respect  to  the 
entrepreneur  function,  in  so  far  as  it  is  not  a  matter  of  natural  en- 
dowment merely,  depends  chiefly  on  the  maintenance  of  conditions 
which  (i)  minimise  the  individual  risk-burden  of  undertaking,  (2) 


VIII]  EFFICIENCY  OF  FACTORS  121 

make  possible  the  quick  and  easy  entry  into,  and  withdrawal  from, 
enterprises,  and  (3)  provide  or  permit  large  profits  where  risk  is 
unavoidably  great. 

ILLUSTRATIVE  PROBLEMS 

1.  Give  two  or  three  ways  in  which  patent  right  laws  contribute  to 
productive  efficiency. 

2.  There  is  much  to  be  said  in  condemnation  of  our  recklessness  in 
permitting  private  individuals  to  exhaust  our  vast  stores  of  natural  wealth 
in  gold,  silver,  oil,  copper,  etc.     What  can  be  said  on  the  other  side? 

3.  Was  there  any  excuse  for  the  great  liberality  displayed  in  the 
granting  of  trolley  car  franchises  in  the  late  eighties? 

4.  Argue  for  the  contention  that  a  much  more  efficient  protection  of 
the  public  against  dishorest  promoters  of  mining  and  other  enterprises 
would  contribute  greatly  to  productive  efficiency. 


CHAPTER  IX 
INCREASE  IN  OUTPUT  AND  RATE  OF  PRODUCTION 

Looking  at  the  situation  broadly,  man  finds  himself  set  over 
against  a  natural  world,  from  which  through  his  own  efforts  and 
sacrifices  he  can  and  must  make  himself  a  living, — can  and  must 
produce  the  goods  necessary  to  life  and  happiness.  This  natural 
world  over  against  which  he  is  set,  and  from  which  he  must  wrest 
a  living,  is  practically  a  fixity:  even  from  the  standpoint  of  many 
generations,  it  experiences  no  increase  in  volume  or  capacity ;  indeed, 
as  respects  important  raw  materials,  it  even  shows  a  diminution. 
On  the  other  hand,  population  in  most  countries,  certainly  in  the 
world  as  a  whole,  constantly  increases.  It  follows  that,  from  a 
natural  plant  which  is  practically  unchanging,  an  ever-increasing 
output  of  economic  goods  must  be  produced.  In  this  situation,  it 
becomes  of  much  importance  that  we  should  study  the  results  which 
follow  our  efforts  to  increase  output,  and  ascertain,  as  far  as  we  may, 
to  what  extent  these  efforts  are  likely  to  be  successful. 

Certain  aspects  of  this  problem  have  already  been  touched  upon, 
at  least  by  implication,  in  discussing  productive  efficiency.  In  view 
of  the  fact  that  different  policies  in  the  conduct  of  production  result 
differently  in  respect  to  the  volume  and  goodness  of  product,  it,  of 
course,  follows  that  we  can  increase  total  output  for  any  given  period 
over  that  of  some  earlier  period,  provided  that  in  the  earlier  period 
we  have  pursued  a  less  efficient  policy  and  are  now  in  a  position  to 
resort  to  the  more  efficient  one.  Further,  as  discovery  and  invention 
supply  us  with  new  and  more  efficient  methods  and  policies,  we  can 
increase  total  product  by  resorting  to  these. 

The  Problem. — But  considerations  such  as  the  above,  though 
of  great  importance,  are  too  evident  to  need  any  prolonged  discussion. 
There  is  a  much  more  difficult  body  of  doctrines  having  their  root  in 
the  fact  that  changes  in  the  proportions  in  which  the  factors  of  pro- 

122 


IX]  OUTPUT  AND  RATE  OF  PRODUCTION  123 

duction  are  combined  are  quite  sure  to  cause  changes  in  the  quantity 
of  product  obtained  per  unit  of  any  one  of  the  factors.  Setting  two 
men  to  work  a  piece  of  land  hitherto  worked  by  only  one  would 
probably  mean  a  larger  total  product ;  three  workers  might  make  the 
product  still  larger ;  and  so  on ;  though  the  time  would  doubtless 
come  when  additions  to  the  amount  of  labor  expended  ceased  to  in- 
crease product,  perhaps  even  reduced  it.  Moreover,  even  while  out- 
put was  being  increased,  the  changes  would  probably  not  be  uniform. 
The  increases  might  be  more  than  proportional  to  the  increases  in  the 
labor,  or  just  proportional,  or  less  than  proportional.  Here,  evident- 
ly, we  have  a  very  fundamental  problem — a  problem  which,  though 
seeming  elementary,  contains  a  veritable  nest  of  complications. 

In  the  above  introduction  to  our  study  of  the  effect  of  changes  in 
combining  proportions,  we  set  out  with  the  fact  that  some  vital 
factors  in  production  are  limited  in  amount  and  so  we  need  specially 
to  know  something  about  the  limits  of  their  productive  capacity.  In 
other  words,  one  problem  involved  in  this  connection  is  to  determine 
the  obstacles  which  meet  us  when  we  try  to  get  more  out  of  a  fixed 
amount  of  some  factor  or  group  of  factors.  The  study  of  this  prob- 
lem, however,  at  once  brings  us  to  a  complemental  problem :  What 
is  the  result  of  trying  to  utilize  a  larger  amount  of  those  factors  which 
can  and  do  change  in  amount?  If,  in  using  the  land  of  a  country, 
we  have  come  to  a  point  where  more  labor  spent  on  the  land  will 
increase  the  product  of  that  land  but  only  at  a  less  than  proportional 
rate,  it  follows  that  we  have  also  reached  a  point  where  we  cannot 
make  as  good  use  of  additional  units  of  labor,  as  we  have  made  of  the 
previous  ones.  These  may  be  thought  of  as  the  principal  problems 
involved  in  our  present  study. 


General  Solution  of  Problem  for  Individual  Productive 
Instruments 

As  already  indicated,  our  problem  is  of  most  significance  when 
we  are  thinking  of  a  whole  people  over  against  its  total  outfit  of 
natural  resources;  but,  manifestly,  we  could  not  expect  to  obtain 
light  on  this  larger  question  unless,  we  had  made  some  study  of 


124  PRINCIPLES  OF  ECONOMICS  [IX 

the  behavior  of  individual  units  of  our  productive  factors.  In  order 
to  learn  how  the  total  outfit  of  a  nation  will  react  when  we  try  to 
increase  its  total  production  by  spending  more  effort  upon  it,  we 
must  first  ascertain  how  a  particular  piece  of  land  or  a  particular 
machine  or  a  particular  power  plant  behaves  under  similar  treatment. 
Accordingly,  this  chapter  is  devoted  to  answering  the  question: 
What  results  follow  when  we  try  to  increase  the  output  from  any 
instrument  of  industry  by  increasing  the  quantity  of  the  auxiliary 
factor  or  factors  combined  with  itf 

Principle  of  the  Three  Stages. — In  making  a  general  answer 
to  this  question,  let  us  suppose  ourselves  to  experiment  with  a  com- 
mon hot-air  furnace  of  the  size  adapted  for  heating  a  12-room  house, 
and  to  ask  what  results  we  should  get  from  using  for  each  experi- 
ment a  larger  charge  of  coal  than  for  the  preceding  one,  the  total 
quantity  to  be  applied  in  a  period  of  two  hours.  If,  for  example, 
we  were  to  make  our  first  experiment  using  10  pounds  of  coal,  in  the 
next  one  20,  in  the  next  30,  and  so  on,  we  may  be  pretty  sure  that 
the  results  would  be  something  like  the  following:  The  first  experi- 
ment would  probably  deliver  no  appreciable  amount  of  hot  air, — the 
heat  produced  being  all  absorbed  by  the  furnace  itself  and  the  con- 
ducting pipes.  The  second  experiment  with  20  pounds  of  coal  might 
supply  enough  heat  to  raise  the  temperature  of  a  room  of  200  cubic 
feet  to  70  degrees.  The  3O-pound  experiment  might  raise  to  the 
same  temperature  twice  as  much  space,  though  the  amount  of  coal 
used  was  only  one-half  greater.  The  4O-pound  experiment  might 
heat  1,000  cubic  feet,  two  and  one-half  times  as  much  as  the  30- 
pound  test,  though  the  increase  in  coal  was  only  one-third.  This 
more  than  proportional  increase  in  the  work  done  might  continue 
for  several  more  experiments.  But  presently  a  test  would  come 
which,  though  showing  some  increase  in  the  total  work  accomplished, 
showed  an  increase  less  than  proportional  to  the  increase  in  the 
charge  of  coal.  Thus  the  8o-pound  test  might  give  us  heat  for  8,000 
feet,  while  the  QO-pound  gave  us  only  enough  for  8,800  feet: — the 
coal  used  increasing  one-eighth,  but  the  work  done  increasing  only 
one-tenth.  Finally,  after  this  less  than  proportional  increase  in  work 
had  gone  on  for  some  time,  a  point  would  be  reached  when  a  larger 


IX]  OUTPUT  AND  RATE  OF  PRODUCTION  125 

amount  of  coal  would  smother  the  fire  and  actually  diminish  the 
amount  of  heat  delivered.  To  summarize,  as  soon  as  our  combina- 
tions began  to  give  results  at  all  they  would  fall  into  three  groups: 
(i)  Output  increasing  more  than  proportionally  to  the  increase  in 
the  auxiliary  factor  (coal)  ;  (2)  output  increasing  less  than  propor- 
tionally; and  (3)  output  diminishing.  For  convenience  in  reference, 
let  us  call  this  tendency  of  the  combinations  the  Principle  of  the 
Three  Stages. 

Of  General  Application. — In  the  above  paragraph,  the  heat- 
ing furnace  supplied  an  illustration  easily  understood  and  one  in 
which  the  truth  of  the  conclusion  laid  down  is  so  evident  as  to  make 
proof  unnecessary.  But  it  will  scarcely  be  doubted  that  the  same 
principle  applies  quite  generally  in  economic  production.  If,  for 
example,  we  were  to  take  a  ten-acre  field  devoted  to  raising  potatoes, 
and,  in  successive  seasons,  use  in  cultivating  that  field  first  i  day's 
labor,  then  5  days',  then  10,  then  15,  and  so  on,  we  should  doubtless 
get  results  analogous  to  those  found  in  coaling  the  furnace.  For 
several  experiments  the  crop  would  increase  more  than  proportion- 
ally to  the  increase  in  the  labor,  then  less  than  proportionally,  and 
finally  would  diminish. 

As  to  the  existence  of  the  first  and  third  stages  indicated,  there 
surely  is  no  room  for  doubt:  the  amount  of  labor  used  might  be  so 
small  that  increasing  it  would  more  than  proportionally  increase  the 
crop,  and  the  amount  of  labor  might  already  be  so  great  that  in- 
creasing it  would  actually  cut  down  the  crop.  As  respects  the  second 
stage,  some  doubts  have  been  expressed,  but  they  seem  to  have  little 
ground.  The  universal  practice  of  farmers  in  a  matter  so  fundamental 
as  this  must  surely  be  based  on  a  trustworthy  induction;  and  that 
practice  fully  confirms  our  contentions  that  the  second  stage  exists. 
First,  farmers  do  not  try  to  raise  all  the  produce  wanted  on  a  single 
piece  of  ground.  Instead,  they  use  many  pieces.  But  this  they 
would  not  do,  if  the  amount  raised  from  one  piece  could  be  increased 
indefinitely  at  the  same  rate  as  the  labor  applied  to  it.  Secondly, 
after  having  extended  cultivation  to  inferior  lands,  they  return  to 
spend  more  labor  on  the  superior  ones,  when  the  price  rises  high 
enough  to  warrant  spending  the  additional  labor  for  a  smaller  pro- 


126  PRINCIPLES  OF  ECONOMICS  [IX 

portional  return.  And  this  they  would  not  do,  unless  the  policy 
added  something  to  the  crop.  There  is  a  stage,  then,  in  which  output 
is  increasable  but  not  increasable  in  proportion  to  the  increase  in  the 
auxiliary  factor. 

II 

Illustration  from  an  Imaginary  Experiment 

The  above  account  of  the  general  principle  underlying  the  be- 
havior of  individual  industrial  factors  when  we  try  to  increase  output 
by  increasing  the  quantity  of  assisting  factors,  is  so  obviously  true 
for  such  cases  as  those  considered,  so  much  a  matter  of  everyday 
experience,  "that' we  should  almost  seem  justified  in  omitting  its  fur- 
ther discussion.  In  fact,  however,  the  topic  is  extraordinarily  pro- 
lific in  misunderstandings;  so  much  so  that  it  seems  necessary  to 
spend  considerable  effort  in  trying  to  insure  a  clear,  accurate  com- 
prehension of  the  doctrine  itself  and  the  various  corollaries  and  con- 
sequences derivable  from  it.  To  this  end,  we  shall  ask  the  student 
to  follow  the  assumed  results  of  an  imaginary  series  of  experiments, 
embodying  the  working  of  things  in  very  definite  and  detailed  arith- 
metic form. 

In  this  series  of  imaginary  experiments .  we  use  each  time  20 
units  of  one  of  the  factors,  which  we  will  call  N,  and  combine  with 
these  increasing  quantities  of  another  kind  of  factor,  which  we  will 
call  L,  using  first  2  units  of  these  L's,  then  3  units,  the  next  time  4 
units,  and  so  on.  These  figures  are  given  in  the  second  and  third 
columns  of  our  table, — the  first  column  being  used  merely  to  show 
the  number  of  the  combination.  The  quantity  of  output  which  re- 
sults from  each  of  our  imaginary  combinations  is  of  course  assumed 
arbitrarily,  and  appears  in  the  fourth  column.  Thus  the  fifth  combi- 
nation, using  20  N's  with  6  L's,  is  supposed  to  give  84  units  of  prod- 
uct, and  the  ninth  combination,  using  20  N's  with  10  L's,  to  give  200 
units  of  product, 

As  just  indicated,  the  figures  of  the  second,  third,  and  fourth 
columns  contain  the  assumed  conditions  and  the  assumed  general 
results  of  our  series  of;  imaginary  experiments.  In  contrast,  the 
figures  of  the  remaining  columns  are  derived  from  the  data  assumed 
in  the  preceding  ones.  First,  come  the  parenthetical  figures  of  the 


IX] 


OUTPUT  AND  RATE  OF  PRODUCTION 


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/?///*  column.  These  are  intended  to  show  what  the  increase  in  out- 
put would  have  been  if  it  had  been  just  proportional  to  the  increase  in 
the  number  of  L's.  But  a  proportional  increase  means  one  which 


128  PRINCIPLES  OF  ECONOMICS  [IX 

just  maintains  the  average  of  the  last  preceding  combination.  Thus, 
the  average  for  the  fourth  combination  is  7  units  for  each  L,  and 
hence,  if  the  L  of  the  fifth  combination  is  to  maintain  the  average,  it 
must  bring  in  seven  units.  Accordingly,  the  figure  in  this  column 
for  the  fifth  combination  is  7. 

The  figures  in  this  fifth  column  which  are  not  in  parenthesis 
represent  the  actual  increase  in  output,  and  are,  of  course,  obtained 
for  any  particular  combination  by  subtracting  from  the  total  of  that 
combination  the  total  of  the  combination  next  preceding.  Thus  from 
the  312  output  of  the  thirteenth  combination,  we  subtract  the  290  of 
the  twelfth  and  get  22,  the  actual  increase  for  the  former  combina- 
tion, and  this  figure,  therefore,  appears  in  the  fifth  column  outside 
the  parenthesis. 

The  figures  in  the  sixth  column  give  the  average  total  output  for 
the  corresponding  combination  measured  in  N's.  Thus  the  figure 
14.5  in  this  column  for  combination  12  means  that  the  average  output 
for  each  of  the  20  N's  in  this  combination  is  14.5.  That  figure 
is  of  course  obtained  by  dividing  290,  the  total  output  for  this  combi- 
nation, by  20,  the  number  of  N's  used.  The  figures  of  the  seventh 
column  similarly  show  the  average  total  output  measured  in  Us.  Thus 
the  1 8.  i  appearing  in  this  column  under  this  same  combination  means 
that  the  average  output  for  each  L  is  18.1,  a  figure  obtained  by  divid- 
ing the  total  output,  290,  by  16,  the  number  of  L's  in  this  combina- 
tion. 

Finally,  we  have  in  the  eighth  column,  the  addition  to  output  which 
follows  upon  4  the  addition  of  one  units  of  L's.  Thus  the  12  appear- 
ing in  this  column  under  the  twelfth  combination  means  that  for  each 
new  L  appearing  in  this  combination,  12  more  units  of  product  appear 
in  the  output.  This  figure  is  of  course  obtained  by  dividing  24,  the 
total  amount  added,  by  2,  the  number  of  L's  added.  In  the  first  8 
combinations  the  figures  for  this  column  are  the  same  as  those  which 
appear  in  column  5  outside  parentheses,  because  in  each  case  there 
is  but  one  L  added,  and  so  division  by  the  number  of  L's  does  not 
alter  the  figure  of  the  addition. 


4  This  must  not  be  understood  to  mean  that  this  addition  is  produced 
solely  by  the  unit  of  L's  in  question. 


IX]        OUTPUT  AND  RATE  OF  PRODUCTION         129 

A  brief  inspection  of  our  table  will  show  that  it  represents 
symbolically  the  phenomena  which  were  set  forth  above  as  present  in 
real  life.  No  actual  combinations  of  factors  behave  in  precisely  the 
way  indicated  in  this  table ;  but  the  general  course  of  things  is  strictly 
regarded.  We  have  but  to  follow  the  figures  given  in  the  fifth 
column  to  see  that,  for  the  first  9  combinations,  output  increases  more 
than  proportionally ;  that,  for  the  next  10  combinations,  it  increases 
less  than  proportionally;  and  that,  for  the  last  8  combinations,  it 
absolutely  diminishes.  In  short,  it  passes  through  the  3  stages 
through  which  real  combinations  pass.  Accordingly,  we  can  safely 
use  the  figures  of  this  table  to  bring  out  in  definite  and  precise  form 
the  points  directly  or  indirectly  involved  in  our  principle. 

ILLUSTRATIVE  PROBLEMS 

1.  Assume  that  the  total  output  for  the  twelfth  combination  is  294 
units  instead  of  290,  and  compute  the  figures  which  would  result  from 
this  new  assumption  in  the  part  of  the  fifth  column  not  in  parenthesis, 
and  in  the  sixth,  seventh,  and  eighth  columns. 

2.  If  you  had  at  your  disposal  10  N's  and  8  L's,  what  combination 
would  you  naturally  use?     What  one,  if  you  had  40  N's  and  32  L's? 
If  you  had  5  N's  and  4  L's  ?    60  N's  and  75  L's  ? 

3.  If  you  had  at  your  disposal  60  N's  and  48  L's,  how  much  product 
would  you  naturally  be  getting?     How  much  would  you  naturally  get, 
if  you  were  to  put  in  6  more  L's?     How  much,  if  you  added  another 
6  L's? 

Ill 

Changes  Caused  in  Averages  as  Measured  in  Each  of  the  Two 

Factors 

Average  Measured  in  L's. — The  next  point  to  be  remarked 
concerns  the  changes  caused  in  the  average  output  as  measured  in  one 
or  the  other  of  the  factors.  This  is,  indeed,  only  another  way  of 
looking  at  the  facts  already  presented,  but  it  is  a  way  of  much  interest 
and  importance.  How,  then,  does  the  average  measured  in  L's  be- 
have? The  seventh  column  of  our  table  shows  that  it  increases  up  to 
the  ninth  combination,  then  diminishes  to  the  end.  Moreover,  the 
table  shows  a  perfectly  definite  reason  why  this  must  be  so.  The 
average  output  for  any  combination,  measured  in  L's,  is,  of  course, 


130 


PRINCIPLES  OF  ECONOMICS 


[IX 


equal  to  the  total  output  for  that  combination  divided  by  the  number 
of  L's  used  in  the  combination.  But,  if  for  any  series  of  combina- 
tions the  total  output  is  increasing  more  rapidly  than  the  number  of 
L's,  (as  it  is  for  the  first  9  combinations),  the  quotient  obtained, 
that  is,  the  average,  must  be  increasing.  On  the  other  hand,  if  for 
any  series  of  combinations  the  total  output  is  increasing  less  rapidly 
(as  it  is  for  the  10  combinations  after  the  ninth)  than  the  number  of 
L's,  the  quotient,  and  so  the  average,  must  be  diminishing.  Finally, 
if  output  is  diminishing  absolutely  while  the  number  of  L's  is  still 
increasing,  the  average  must  of  course  be  diminishing.  The  average, 


1  2  3  4  6  6  7  8  9  10  11  12  13  14  15  16  17  18  19  20  21  22  23  24  25  26  27 


N 


\ 


\ 


\ 


Averages  in  L's  and  N's 

measured  in  L's,  therefore,  first  increases  up  to  the  ninth  combina- 
tion, then  diminishes  to  the  end. 

Average  Measured  in  N's. — The  behavior  of  the  average 
measured  in  N's,  as  represented  in  the  sixth  column,  is  necessarily 
somewhat  different.  Since  the  total  output  is  increasing  up  to,  and 
including,  the  nineteenth  combination,  while  all  the  time  the  number 
of  N's  used  remains  constant, — that  is,  since  the  dividend  increases 
while  the  divisor  remains  constant — the  average,  measured  in  N's, 
must  increase  throughout  this  series.  On  the  other  hand,  since  the 
total  diminishes  after  the  nineteenth  combination  while  the  number 
of  N's  remains  constant,  the  average,  measured  in  N's,  must  diminish 
after  the  nineteenth  to  the  end. 

Summary. — Summarizing  the  points  made  above  and  the 
most  immediate  inferences  therefrom,  we  have  the  following:  First, 


IX]         OUTPUT  AND  RATE  OF  PRODUCTION         131 

each  average  rises  during  a  series  of  combinations ;  reaches  a  maxi- 
mum in  one  particular  combination;  then  diminishes  for  the  re- 
mainder. Secondly,  the  maximum  average  combination  is  differ- 
ent for  the  two  averages,  being  an  early  one  for  the  L-average,  a 
late  one  for  the  N-average, — a  proposition  which  plainly  follows 
from  the  conditions.  In  the  third  place,  the  average  measured  in 
cither  factor  is  bound  to  be  an  increasing  one  for  every  combina- 
tion prior  to  the  tenth ;  that  average  measured  in  either  factor  will 
be  a  diminishing  one  for  every  combination  after  the  nineteenth; 
and,  for  the  intervening  combinations,  the  average  will  be  a  dimin- 
ishing one,  measured  in  L's,  but  an  increasing  one,  measured  in  N's. 
These  points  are  brought  out  graphically  in  the  accompanying  dia- 
gram, in  which  the  continuous  curve  represents  the  averages  measured 
in  L's,  while  the  dotted  curve  represents  the  averages  measured 
in  N's. 

IV 

Changes  in  Additions  or  Marginal  Products 

Another  effect  of  attempting  to  increase  output  by  increasing  one 
of  the  factors  concerns  the  changes  caused  in  the  addition  to  output 
as  measured  in  the  addition  to  the  changing  factor.  Thus  the  thir- 
teenth combination  shows  an  increase  over  the  preceding  one  of 
22  units  of  output,  while  the  number  of  L's  added  to  make  this 
combination  was  2;  and,  dividing  22  by  2,  we  have  u,  which  is  the 
number  of  units  of  product  added  for  each  of  the  L's  added. 
With  some  show  of  reason,  this  quantity  is  frequently  designated  the 
marginal  product 5  of  the  L's — that  is,  of  the  increasing  factor. 
Anyhow,  the  course  which  it  takes  as  we  increase  the  quantity  of 
L's  used  is  of  considerable  importance.  That  course  is  indicated  in 
the  last  column  of  our  table.  It  begins  at  4  in  the  second  com- 
bination ;  increases  to  49  in  the  fifth ;  from  thence  grows  smaller 
and  smaller  to  the  nineteenth ;  after  which  it  remains  less  than  o. 

These  results  are  inevitable  so  long  as  the  relation  between 
the  increase  in  output  and  the  increase  in  the  number  of  L's  is  the 
exact  relation  assumed  in  our  table.  The  addition  to  output  for  each 


"'  See  Note  2,  Appendix. 


132  PRINCIPLES  OF  ECONOMICS  [IX 

added  L  is  just  what  it  is  because  the  relation  between  the  increase 
in  the  total  output  and  the  increase  in  the  total  number  of  L's  is 
just  what  it  is.  We  must  not  infer,  however,  that  the  precise  course 
taken  by  the  marginal  additions  in  our  table  is  the  only  one  which 
they  could  take  under  the  general  conditions  assumed,  namely,  the 
conditions  that  output  increased  more  than  proportionally  up  to  the 
ninth  combination  inclusive,  then  less  than  proportionally  to  the  nine- 
teenth, and  then  diminished.  The  precise  course  taken  by  the 
marginal  addition  or  product  as  a  result  of  a  change  in  the  propor- 
tion between  output  and  the  number  of  L's,  depends,  not  only  on 
the  direction  of  that  change,  but  also  on  its  degree.  Thus,  if  the 
proportional  increase  in  output  had  been  less  rapid  during  the 
earlier  combinations  or  had  fallen  off  less  sharply  in  the  later  ones, 
the  change  from  an  increasing  to  a  diminishing  marginal  product 
would  have  come  later.  Other  possible  variations  in  the  behavior 
of  the  marginal  product  from  that  indicated  in  our  table  could 
easily  be  worked  out  arithmetically.  Nevertheless,  if  we  assume 
that  the  course  taken  by  the  output  in  our  imaginary  experiment 
was  fairly  typical, — and  I  think  we  may  properly  do  so, — the  course 
taken  by  the  marginal  product  would  correspond  in  a  general  way 
to  that  which  it  takes  in  our  table:  that  is,  marginal  product  would 
increase  up  to  a  maximum  coming  somewhat  earlier  than  the  com- 
bination at  which  the  increase  in  output  became  less  than  propor- 
tional, then  diminish  to  the  end. 

Before  leaving  this  topic,  we  must  emphasize  one  aspect  of  the 
matter  just  commented  upon, — the  fact  that  the  point  where  marginal 
product  begins  to  diminish  does  not  correspond  with  the  point  where 
the  increase  in  output  changes  from  a  more  than  proportional  to  a 
less  than  proportional  one, — the  latter  being  at  the  tenth  combination, 
the  former  at  the  sixth.  As  already  noted,  this  precise  location  of  the 
point  at  which  the  marginal  product  begins  to  decline  is  not  neces- 
sary for  every  possible  case  in  which  the  increase  begins  to  be  less 
than  proportional  at  the  tenth  combination.  In  other  words,  our 
experiment  does  not  prove  that  a  locating  of  the  change  in  marginal 
product  at  a  point  earlier  than  that  at  which  the  change  in  propor- 
tionality takes  place  is  inevitable;  it  does  prove,  however,  that  this 
is  possible,  if  not  probable,  It  follows  that  we  cannot  properly 


IX)      OUTPUT  AND  RATE  OF  PRODUCTION      133 

treat  the  two  phenomena  as  identical.  The  principle  that  the  mar- 
ginal product  first  increases,  then  diminishes,  is  not  the  same  as  the 
principle  that  output  increases  more  than  proportionally  to  the 
changing  factor,  then  less  than  proportionally.6  It  should  be  added, 
however,  that,  generally  speaking,  we  have  no  interest  in  marginal 
products  prior  to  the  ninth  combination.  These  marginal  product 
figures  are  useful  chiefly  in  showing  us  whether  or  not  it  would 
pay  to  add  further  to  the  number  of  L's  in  the  combination.7  But  it 
goes  without  saying  that  such  is  the  case  anyhow  up  to  the  ninth 
combination.  For  up  to  that  point  we  are  raising  both  averages  by 
each  addition  of  L's;  and,  as  long  as  this  is  true,  it  is  a  matter  of 
indifference  whether  or  not  each  L  adds  as  much  as  its  predecessor. 

V 
Factor  L  Constant,  Factor  N  Changing 

In  our  imaginary  experiment  as  embodied  in  the  table,  the  quan- 
tity of  N's  was  supposed  to  be  constant  while  that  of  L's  increased. 
What,  now,  would  be  the  result  were  this  situation  to  be  reversed 
with  the  L's  constant  and  the  N's  increasing  ?  It  would  be  precisely 
similar  to  that  already  brought  out,  with  the  places  of  N's  and 
L's  reversed.  Output  would  increase  at  first  more  rapidly  than 
the  N's,  then  less  rapidly,  then  actually  decrease ;  the  average 
measured  in  N's  would  increase  up  to  some  early  combination,  then 
diminish  to  the  end,  while  the  average  measured  in  L's  would  in- 
crease up  to  some  later  combination,  then  diminish  to  the  end ;  and, 
finally,  the  marginal  additions,  the  marginal  product  of  N's,  would 
increase  up  to  some  combination  prior  to  the  ninth,  then  diminish 
to  the  end.  And  note  that  the  acceptance  of  these  statements  does 
not  depend  on  a  new  induction.  //  the  points  made  with  respect 
to  the  results  which  follow  when  N's  are  kept  constant  and  L's 
increased  are  true,  the  analogous  statements  with  respect  to  the 


fc  This  comment  seems  necessary  on  account  of  occasional  carelessness 
of  statement  on  this  point  in  the  literature  of  our  subject. 

7  Many  economists  hold  that  the  marginal  product  is  also  very  useful 
in  guiding  us  as  to  the  importance  or  significance  to  the  producer  of  the 
factor  in  question. 


134  PRINCIPLES  OF  ECONOMICS  [IX 

results  which  follow  when  L's  are  kept  constant  and  N's  increased 
must  be  true.  A  table  reversing  the  relations  of  L's  and  N's,  in 
respect  to  both  conditions  and  results,  is  directly  dcducible  from  the 
table  already  given.  Accordingly,  in  so  far  as  the  doctrines  set 
forth  in  the  preceding  discussion  apply  to  any  particular  combina- 
tion, they  are  true  without  regard  to  which  of  the  factors  is  kept 
constant  and  which  is  increased.  If  they  are  true  of  a  combination 
of  land  and  labor  in  which  the  land  is  constant,  they  are  equally 
true  of  one  in  which  the  labor  is  constant. 

The  point  just  made,  that  the  principles  laid  down  with  respect 
to  the  effect  of  increasing  one  of  the  factors  of  a  combination  while 
the  other  remains  constant  are  true  whichever  one  of  the  factors  is 
increased,  must  not  be  understood  as  implying  that  it  is  of  no  prac- 
tical importance  which  factor  is  taken  as  the  constant  one.  Some 
natural  factors  in  production  and  many  produced  ones  necessarily 
appear  in  large,  indivisible  units.  They  must  be  utilized  as  a  whole 
or  not  at  all.  For  example,  the  group  of  great  lakes  beginning  with 
Superior  and  ending  with  Ontario — a  very  important  factor  in 
transportation — cannot  be  made  smaller  or  larger.  We  must  use  the 
system  as  it  is. 

So  a  plant  for  lighting  a  great  city  or  supplying  it  with  water 
cannot  be  changed  ever  week  or  month  or  year.  If  we  have  to 
increase  or  diminish  the  amount  of  service  obtained  from  factors 
of  this  type,  we  must  for  a  time  if  possible  do  so  by  increasing  the 
quantity  of  auxiliary  factors  used.  Such  increasing  of  the  auxiliary 
factors  is  usually  possible,  because  those  factors  are  to  be  had  in 
small  or  easily  divisible  units.  While  we  cannot  increase  the  size 
of  the  lakes,  we  can  change  in  no  great  length  of  time  the  number 
of  boats  navigating  those  lakes.  While  we  cannot  at  frequent  in- 
tervals enlarge  the  whole  lighting  plant,  we  can  readily  increase  the 
amount  of  labor  employed  or  the  quantity  of  coal  consumed. 

The  importance  of  the  principles  brought  out  in  this  chapter 
grows  out  of  their  application  to  cases  like  these  in  which  one  of 
the  combining  factors  is  naturally  or  necessarily  kept  constant  for 
a  shorter  or  longer  period,  while  any  or  all  of  the  others  may  be 
changed. 


IX]         OUTPUT  AND  RATE  OF  PRODUCTION         I35 

VI 
Output  from  Groups  of  Factors 

We  have  noted  the  effect  on  output  of  increasing  one  of  the 
factors  of  a  combination  when  we  are  dealing  with  single  factors. 
We  have  to  add  that  the  same  phenomena  appear  when  we  are 
dealing  with  groups  of  factors  over  against  one  or  more  auxiliary 
factors.  ,  Thus,  when  trying  to  ascertain  the  effect  on  output  from 
the  aggregation  of  land,  buildings,  machinery,  etc.,  which  we  call 
a  plant,  of  increasing  the  amount  of  auxiliary  factors,  raw  mate- 
rials, fuel,  labor,  etc.,  we  have  the  same  general  experience  as  before. 
For  a  time,  the  output  increases  more  rapidly  than  the  auxiliary 
factors,  then  less  rapidly,  then  absolutely  diminishes. 

The  same  statement  would  of  course  apply  to  a  business  unit 
as  a  whole,  that  is,  a  partnership  or  a  corporation  operating  one  or 
many  plants.  This  would  be  so,  partly  because  the  plants  operated 
by  the  corporation  would  exhibit  the  phenomena  in  question  and 
partly  because  the  organization  side  of  the  business  would  inde- 
pendently exhibit  these  phenomena.  While  parts  of  the  organization 
remained  constant — for  example,  the  higher  officials,  one  president, 
one  secretary,  and  one  general  manager, — other  elements  would  be 
increased,  and  this  increase  would  at  some  stages  result  in  a  more 
than  proportional  increase  in  output  and  at  others  in  a  less  than  pro- 
portional one. 

In  general,  then,  it  is  scarcely  to  be  doubted  that  we  have 
here  a  principle  or  set  of  principles  of  very  wide  application.  In 
practically  all  cases,  we  may  alter  the  proportions  in  which  factors 
are  combined  without  destroying  their  power  to  produce ;  but  we 
cannot  help  changing  their  effectiveness  or  productivity,  making 
them  produce,  proportionally,  more  or  less.  And  this  fact  will  be  of 
importance  whenever  the  circumstances  are  such  that  some  one  factor 
or  group  of  factors,  is  absolutely  fixed,  or,  for  a  longer  or  shorter 
period,  is  fixed  by  special  circumstances. 


CHAPTER  X 

ATTEMPTS  TO  INCREASE  OUTPUT  AND  SOME 
ECONOMIC  CONSEQUENCES 

In  the  last  chapter  we  explained  the  more  immediate  and  chiefly 
technical  consequences  resulting  when  we  attempt  to  increase  the 
output  from  a  factor  of  production  by  increasing  the  amount  of  the 
auxiliary  factors  employed.  We  must  now  remark  on  some  remoter 
consequences, — especially  some  of  an  economic  character. 

I 
Limits  of  the  Productive  Capacity  of  Individual  Instruments 

As  noted  in  introducing  our  last  chapter,  one  of  the  most  im- 
portant economic  problems  connected  with  the  matter  we  are  now 
studying  concerns  the  limits  of  our  productive  capacity.  In  so  far 
as  this  inquiry  has  to  do  with  the  individual  instrument,  the  most 
valuable  conclusions  of  our  study  are  these  two:  (i)  There  is  an 
absolute  limit  to  the  amount  obtainable  from  any  instrument,  and 
(2)  before  that  absolute  limit  is  reached,  there  is  a  stage  during 
which  the  increase  in  output  is  less  than  proportional  to  the  increase 
in  the  quantity  of  auxiliary  factors.  On  account  of  its  great  im- 
portance, the  second  of  these  ought,  perhaps,  to  be  given  the  em- 
phasis derivable  from  its  statement  as  a  formal  principle.  This 
principle  is  commonly  known  as  the  Law  of  Diminishing  Returns. 

Principle — The  Law  of  Diminishing  Returns. 

//  attempts  are  made  to  increase  indefinitely  the  output 
of  any  factor  of  production  by  increasing  the  quantity  of 
auxiliary  factors  used,  a  time  zvill  come,  before  the  absolute 
limit  is  reached,  when,  though  there  continues  to  be  an 
increase  in  output,  that  increase  is  less  than  proportional  to 
the  increase  in  the  quantity  of  assisting  factors  added. 


X]  INCREASE  IN  OUTPUT:     CONSEQUENCES  137 

We  must  now  add  a  word  about  certain  technical  phrases  used 
in  connection  with  the  principle  just  stated:  When  the  utilization 
of  any  instrument  of  production  has  been  carried  up  to  the  com- 
bination which  will  yield  only  a  smaller  proportional  return,  it 
is  said  to  have  been  worked  or  utilized  to  "the  point  of  diminish- 
ing returns."  A  step  further  takes  it  beyond  the  point  of  dimin- 
ishing returns  or  into  the  stage  of  diminishing  returns.  As  the 
utilization  of  any  instrument  is  carried  further  and  further  into 
the  stage  of  diminishing  returns,  it  is  said  to  be  worked  (culti- 
vated in  the  case  of  land)  "intensively"  or  "more  intensively." 
Another  method  of  expressing  the  same  idea  is  to  say  that  "the  margin 
of  cultivation  (utilization)  is  lowered"  or  "pushed  down." 

The  discussion  leading  up  to  the  above  statement  of  the  prin- 
ciple of  diminishing  returns  has,  perhaps,  insured  its  correct  inter- 
pretation. In  view,  however,  of  numerous  misunderstandings  which 
have  appeared  in  economic  controversy,  it  seems  best  to  indicate 
specifically  certain  misinterpretations  which  need  to  be  guarded 
against.  First,  the  "returns"  referred  to  in  the  designation  "diminish- 
ing returns"  are  physical  returns, — product,  not  money  or  profits. 
The  principle  means  that  by  increasing  the  amount  of  labor  we 
can  increase,  though  less  than  proportionally,  the  potatoes  raised 
on  a  given  piece  of  ground,  or  the  heat  given  out  by  a  furnace,  or 
the  freight  carried  by  a  railway,  and  so  on. 

In  order  to  emphasize  this  point,  I  like  to  call  our  principle 
the  Law  of  Diminishing  Output,  thus  avoiding  the  ambiguity 
attaching  to  the  word  "returns." 

Another  misunderstanding  confuses  the  principle  now  under 
discussion  with  one  which  says  that  there  comes  a  stage  in  the  pro 
duction  of  goods  when  product  can  be  increased  only  at  increasing 
cost.  This  statement  is  without  doubt  true ;  but,  as  will  be  brought 
out  in  the  next  chapter,  the  condition  indicated  is  not  identical  with 
the  one  meant  when  we  say  that  we  have  reached  the  stage  of 
diminishing  returns. 

Another  troublesome  misunderstanding  interprets  our  principle 
to  mean  that  output  could  never  be  increased  at  a  proportional 
rate  whatever  might  happen,  however  much  improvement  in  the 
productive  arts  might  take  place.  This,  of  course,  is  a  quite  illegiti- 


138  PRINCIPLES  OF  ECONOMICS  [X 

mate  interpretation.  A  natural  law  in  Economics,  just  as  in 
Chemistry  or  Physics  or  Biology,  assumes  the  continuity  of  condi- 
tions other  than  the  one  or  more  which  the  principle  itself  represents 
as  changing.  Doubtless  any  person  is  at  liberty  to  affirm  a  principle 
analogous  to  the  one  here  considered  in  a  dynamic  sense,  as  we 
sometimes  say,  that  is,  as  certain  to  prove  true  despite  changing 
conditions.  But  most  prudent  people  will  hesitate  to  do  so;  and 
anyhow,  unless  this  is  expressly  indicated,  the  affirmation  is  always 
made  subject  to  the  condition  that  no  changes  are  to  take  place 
except  the  one  specified  in  the  principle  itself,  namely,  an  increase 
in.the  quantity  of  the  changing  factor. 

ILLUSTRATIVE  PROBLEM 

"Malthus  was  quite  wrong  when  he  tried  to  show  that  at  life's  ban- 
quet there  was  room  for  only  a  limited  number  of  guests.  The  guests 
are  also  cooks,  contributing  their  share  of  the  banquet." — Dr.  Bertillon 
in  a  lecture  in  Paris  in  1913. 

Criticize  this  statement  of  Bertillon  on  the  basis  of  the  law  of  dimin- 
ishing returns. 

II 
Elasticity  of  the  Limit  Set  by  the  Lav/  of  Diminishing  Returns 

In  our  formulation  of  the  Law  of  Diminishing  Returns,  and 
too  often  in  our  interpretation  of  that  law,  all  emphasis  is  laid  on 
the  fact  that  it  acts  as  a  check  on  output, — sets  a  limit  to  output. 
Only  a  very  little  thought  makes  it  clear  that  this  principle  has 
another  side.  It  is  true  that  output  does  not  increase  proportionally 
to  the  increase  in  auxiliary  factors ;  but  then  output  does  increase.  If 
we  have  reached  the  stage  of  diminishing  returns  in  the  utilization 
of  any  instrument  of  production,  we  cannot  get  any  more  product 
out  of  it  at  the  same  rate  as  before;  but  we  can  get  some  more. 
In  fact,  our  principle  might  with  very  good  reason  be  named  the 
Principle  of  Output  Increasable  at  a  Diminishing  Rate.  Such  a 
designation  recognizes  equally  the  fact  that  output  can  be  increased 
and  the  fact,  also,  that  the  increase  will  be  less  than  propor- 
tional. 


X]  INCREASE  IN  OUTPUT:     CONSEQUENCES  139 

ILLUSTRATIVE  PROBLEM 

The  law  of  diminishing  returns  is  a  reason  why  the  price  of  wheat  is 
lower  than  it  might  be,  and,  at  the  same  time,  is  a  reason  why  the  price 
of  wheat  is  higher  than  it  might  be.  Explain  the  seeming  contradic- 
tion. 


Ill 

All  Divisible  Factors  Usually  Being  Worked  in  the  Stage  of 
Diminishing  Returns 

We  have  seen  that  most  economic  factors  are  subject  to  the  law 
of  diminishing  returns  in  the  sense  that,  in  trying  to  utilize  them 
more  and  more  fully,  a  time  will  come  when  such  attempts  will 
increase  product,  but  increase  it  less  than  proportionally.  We  now 
have  to  add  that,  under  normal  conditions,  the  utilisation  of  any 
divisible  factor  must  have  been  carried  into  this  stage, — producers 
must  be  working  it  in  some  combination  beyond  the  point  of  diminish- 
ing returns.  In  terms  of  our  table,  any  such  instrument  will  at  all 
times  be  working  in  some  combination  later  than  the  ninth  and 
earlier  than  the  nineteenth. 

The  general  argument  on  which  the  above  statement  is  based 
is  as  follows : 

All  combinations  earlier  or  later  than  those  indicated  are  ex- 
cluded as  being  for  one  reason  or  another  illegitimate.  First,  all 
combinations  coming  after  the  nineteenth  must  be  excluded,  since 
the  additions  to  the  changing  factor  which  make  up  these  combina- 
tions reduce  the  total, — a  result  which  can  be  avoided  by  the  simple 
expedient  of  not  making  those  additions.  Secondly,  all  combina- 
tions from  the  first  to  the  eighth  inclusive  must  be  excluded ;  since, 
under  our  hypothesis  that  the  factor  under  consideration  is  divisible, 
we  could  transform  any  one  of  these  early  combinations  into  the 
ninth  by  the  simple  expedient  of  discarding  some  of  the  N's,  and,  in 
doing  this,  would  increase  our  total.  Thus,  the  seventh  combination, 
20  N's  with  8  L's,  could  be  transformed  into  the  ninth  by  discarding 
4  of  the  N's,  making  the  combination  16  N's  with  8  L's, — the  same 
2  to  i  ratio  as  that  of  the  ninth.  But  this  combination  would  give 


I40  PRINCIPLES  OF  ECONOMICS  (X 

us  8  times  20  or  160  units  of  product,  whereas  the  original  com- 
bination of  20  N's  with  8  L's  would  give  us  only  156  units. 

We  have  seen  that,  under  normal  conditions,  no  divisible  factor 
would  be  used  in  any  combination  later  than  the  nineteenth  nor 
earlier  than  the  ninth.  That  is,  the  actual,  effective  working  of 
any  factor  would  be  limited  to  some  one  of  the  n  combinations 
from  the  ninth  to  the  nineteenth  inclusive.  But  we  must  narrow 
still  further  the  range  of  reasonable,  and  so  actual,  combinations. 
Another  element  necessarily  comes  in  to  determine  what  ones  are 
possible,  namely,  cost  of  production.  If  N's  could  be  had  in  un- 
limited abundance  for  nothing,  while  L's  had  a  price  however 
small,  the  ninth  combination  would  plainly  be  the  most  desirable, 
since  it  gives  the  highest  average  measured  in  L's,  and  so,  when  the 
price  of  the  L's  constituted  the  only  cost,  the  cost  in  this  combination 
would  be  lowest.1 

On  the  other  hand,  if  N's  had  a  price,  but  L's  none,  the  nine- 
teenth combination  would  be  the  cheapest,  and,  so,  the  most  desir- 
able of  all.  But,  in  real  life,  both  N's  and  L's  will  have  some 
cost,  else  they  would  not  be  economic  factors  at  all.  Further, 
there  will  not  often  be  such  a  difference  between  their  costs  that 
either  is  negligible  in  the  total  cost.  It  follows  that,  if  both 
factors  are  divisible,  the  truly  legitimate  combination  will  normally 
be  one  which  comes  later  than  the  ninth  and  earlier  than  the  nine- 
teenth. 

Assuming  reasonable  conduct  on  the  part  of  producers,  they 
will  be  using  any  factor  in  some  one  of  the  combinations  indi- 
cated,— the  combinations  lying  between  the  ninth  and  the  nineteenth. 
But  any  one  of  these  is  bound  to  be  a  diminishing-returns  combina- 
tion, that  is,  one  holding  such  a  position  that,  if  we  try  to  increase 
output  by  increasing  the  quantity  of  auxiliary  factors,  we  shall 
effect  some  increase  but  an  increase  which  is  less  than  proportional 
to  the  increase  in  auxiliary  factors.  We  conclude,  then,  that,  in 
actual  life,  we  should  expect  to  find  any  divisible  factor  being 
worked  in  the  condition  of  diminishing  returns. 


1  This   would    be    true   even    if    N's   had   a    price,   but   one   which    was 
insignificant  as  compared  with  that  of  L's. 


X]  INCREASE  IN  OUTPUT:     CONSEQUENCES  141 


IV 

Indivisible  Factors  May  Be  Working  in  the  Stage  of  Increasing 

Returns 

We  have  just  seen  that  divisible  factors  will  normally  be  used 
in  the  condition  of  diminishing  returns,  because  on  account  of  the 
divisibility  of  the  factor  which  was  kept  constant  in  our  experi- 
ments, we  could  always  change  to  a  later  combination,  and  would 
do  so  if  this  was  desirable.  But,  when  we  come  to  deal  with  indi- 
visible or  large-unit  factors,  the  problem  is  greatly  altered.  Just 
because  the  given  factor  is  indivisible,  we  cannot  adapt  it  promptly 
to  every  change  in  the  need  for  product.  Thus,  it  is  plain  that  we 
cannot  change  our  furnace  every  time  the  weather  changes,  substi- 
tuting a  larger  one  if  more  heat  is  needed  or  a  smaller  one  if  less 
heat  is  needed.  What  we  have  to  do  is  to  run  the  one  we  have 
harder  or  easier, — put  in  coal  oftener  or  less  often.  An  obvious 
result  of  this  situation  is  that,  if  the  weather  gets  warmer,  we  may 
be  obliged  to  run  the  furnace  so  low  that  it  is  being  worked  in 
some  stage  prior  to  the  ninth,  say  the  seventh  or  the  fourth.  This 
of  course  is  uneconomical :  we  get  much  less  heat  per  pound  of  coal 
than  we  might  if  our  plant  were  adapted  to  just  the  need  of  the 
moment.  But  we  have  no  choice.  We  must  install  a  furnace  large 
enough  to  meet  the  need  of  really  cold  weather ;  and  yet,  on  a 
moderate  day,  we  must  not  work  it  hard  enough  to  make  the  house 
uninhabitable.  It  follows,  then,  that  we  may  find  any  indivisible 
factor  being  used  in  the  stage  of  increasing  returns,  output  increas- 
able  at  an  increasing  rate. 

What  we  have  just  said  of  the  furnace  applies  as  well  to  any 
large  natural  factor,  for  example,  the  lake  system  used  for  illustra- 
tion on  page  134.  Such  a  factor  may  be  working  in  the  condition 
of  increasing  returns  or  in  that  of  diminishing  returns.  Which  it 
will  be  depends  entirely  on  the  existing  need  for  the  services  of  the 
factor.  We  have  no  choice  in  the  matter.  We  have  to  use  it  as 
it  is  whether  the  need  be  great  or  small.  For  a  long  period  while 
population  was  small,  this  vast  system  of  waterways  could  be 
utilized  only  in  some  inferior  combination,  some  one  earlier  than 


I42  PRINCIPLES  OF  ECONOMICS  [X 

our  ninth.  With  the  increase  of  population  during  the  last  fifty 
years,  it  probably  has  passed  into  some  combination  later  than  the 
ninth. 

The  case  of  indivisible,  large-unit  factors  of  the  producible  sort 
is,  naturally  enough,  different.  We  have  some  control  of  the  situa- 
tion in  that,  when. constructing  such  instruments,  we  can  adapt  them 
to  a  particular  output, — make  them  of  the  proper  size  to  supply 
this  output  most  cheaply.  But,  as  a  matter  of  course,  they  will 
be  called  on  to  supply  different  volumes  of  output  at  different  times. 
Naturally,  the  volume  for  which  they  will  be  planned  will  be  that 
one  which  is  expected  to  be  normal.  They  will,  therefore,  be  built 
on  a  scale  which  enables  them  to  supply  this  normal  output  when 
working  in  the  combination  showing  least  cost.2  It  follows  that, 
under  normal  conditions,  such  indivisible  producible  factors  will  be 
working  in  that  particular  combination  lying  between  the  ninth  and 
the  nineteenth  which  shows  least  cost.  If,  however,  the  demand 
is  abnormally  large,  they  will  be  pushed  into  some  later  combination ; 
while,  on  the  other  hand,  if  it  is  abnormally  small,  they  will  be 
brought  back  into  some  combination  lying  between  the  least-cost 
one  and  the  ninth,  or,  even,  into  one  earlier  than  the  ninth. 

ILLUSTRATIVE  PROBLEM 

In  what  stage,  as  respects  returns,  would  you  expect  to  find  an  auto- 
mobile plant  working  during  an  industrial  depression?  After  business 
had  revived?  When  a  boom  was  on? 

V 
The  Diminishing  Marginal  Significance  of  Factors 

One  more  important  fact  which  in  part  anyhow  grows  out  of  our 
effort  to  increase  output  by  increasing  the  quantity  of  the  auxiliary 
factor  used,  is  suggested  by  the  title  of  this  section :  "The  Diminish- 
ing Marginal  Significance  of  Factors."  In  general  the  different 
units  of  any  particular  kind  of  factor  can  be  put  to  uses  having 


*  They  will  probably  be  built  on  a  little  larger  scale  than  this  in  anticipa- 
tion of  increasing  need. 


X]  INCREASE  IN  OUTPUT:     CONSEQUENCES  143 

different  degrees  of  importance  or  significance.  When  such  uses 
are  wholly  distinct,  this  proposition  is  evident  enough.  Thus,  in 
time  of  war,  the  food  supplied  to  the  soldiers  in  the  field  plays  a 
more  important  role  than  that  destined  for  the  ordinary  civilian; 
and  the  steel  used  in  making  ammunition  is  more  significant  than 
that  devoted  to  making  pleasure  cars.  Even  if  the  different  uses 
have  to  do  with  one  product,  the  case  is  scarcely  less  plain.  Thus, 
the  steel  used  in  the  corn  farmer's  plow  is  more  important  than  that 
used  in  his  spring-toothed  harrow ;  without  the  former  he  could 
scarcely  farm  at  all,  the  latter  he  might  dispense  with  rather  easily. 
Finally,  different  uses  of  the  same  factor  differ  in  importance  or 
significance  even  when  the  factor  is  operating  in  just  the  same  way. 
Thus,  if,  under  similar  conditions,  a  cultivator  goes  over  a  cornfield 
several  times,  the  importance  of  the  service  it  renders  will  be  smaller 
as  the  number  of  times  increases.  This,  manifestly,  is  merely  a 
special  application  of  the  principle  of  diminishing  marginal  produc- 
tivity brought  out  in  the  preceding  chapter. 

But,  not  only  may  the  different  uses  to  which  a  given  factor  is 
put  vary  greatly  in  importance  or  significance,  among  these  different 
significances  there  is  one  which  plays  a  much  more  important  role 
than  the  rest.  That  one  is  the  smallest  or  least  of  them  all.  Thus, 
if  we  have  steel  enough  so  that  we  can  afford  to  use  it  for  both  the 
plow  and  the  spring-toothed  harrow,  the  significance  of  the  steel 
used  in  the  harrow  will  play  a  more  important  part  than  will  the 
significance  of  the  steel  used  in  the  plow.  The  former  rather  than 
the  latter  will  determine  the  estimate  we  put  on  the  importance  of 
the  amount  of  steel  necessary  to  make  a  plow  or  a  harrow.3  The 
reason  is  not  far  to  seek.  Our  estimate  of  the  importance  of 
anything — in  this  case  the  quantity  of  steel  necessary  to  make  either 
a  plow  or  a  harrow — depends  on  how  much  loss  we  should  experience 
if  we  had  to  give  it  up.  But,  if  we  had  to  give  up  either  the  plow 
or  the  harrow,  the  one  chosen  for  the  sacrifice  would,  of  course, 
be  the  harrow,  the  less  important  of  the  two.  The  significance  lost 
to  us,  therefore,  would  be  the  lesser  significance ;  and,  hence,  the 


"As  we  shall  learn  later,  this  estimate  will  have  a  part  in  determining 
the  value  or  price  of  steel. 


I44  PRINCIPLES  OF  ECONOMICS  [X 

estimate  which  we  make  of  the  importance  of  steel  would  be  deter- 
mined by  the  lesser  significance.  Broadening  the  statement  so  as 
to  cover  the  whole  stock  of  steel,  we  say  that  the  estimate  we  make 
of  the  importance  of  steel  would  be  determined  by  its  significance 
in  the  least  important  use, — its  least  significance. 

This  least  significance  of  any  factor  which  is  of  much  importance 
in  economics,  we  designate  its  marginal  significance.  The  designa- 
tion signifies  that  this  particular  significance  is  located  at  the 
boundary  line  separating  the  significances  which  are  realised  from 
those  which  are  not. 

We  have  seen  that  the  differ ent  significances  of  any  factor  are 
quite  unequal,  and  that  one  of  these,  the  marginal  significance,  is 
of  great  moment  in  economic  matters.  We  must  now  add  a  proposi- 
tion which  we  will  call  the  Law  of  Diminishing  Marginal  Sig- 
nificance. 

Principle — The   Law   of   Diminishing   Marginal    Signi- 
ficance. 

Generally  speaking,  the  marginal  significance  of  any 
factor  tends  to  diminish  as  the  quantity  of  that  factor 
available  increases. 

The  marginal  significance  of  a  particular  kind  of  land  will  be 
much  smaller  if  there  are  millions  of  acres  of  such  land  available 
than  it  would  be  if  there  were  only  hundreds.  As  between  different 
kinds  of  land,  the  marginal  significance  of  the  kind  of  which  there 
are  only  hundreds  of  acres  will  very  likely  be  greater  than  the 
marginal  significance  of  a  kind  of  which  there  are  millions  of  acres, 
even  though  the  generic  significance  of  the  latter  kind  is  much 
greater. 

That  things  are  bound  to  work  in  a  way  to  make  the  above 
proposition  true  is  easily  seen.  Assuming  the  general  rationality 
of  business  conduct,  the  uses  to  which  any  factor  has  not  as  yet 
been  put  will  be  less  significant  than  those  to  which  it  has  been  put. 
It  follows  that,  if  new  supplies  of  that  factor  are  forthcoming,  they 
can  be  utilized  only  by  assigning  them  to  uses  which  have  less  sig- 
nificance than  those  already  provided  for.  Hence  the  principle. 


X]  INCREASE  IN  OUTPUT:    CONSEQUENCES  145 

ILLUSTRATIVE  PROBLEM 

Assuming  that  laborers  of  any  class  tend  to  get  a  price  for  their 
services — wages — representing  substantially  the  marginal  importance  of 
their  type  of  service,  show  that  you  would  naturally  expect  restrictions 
on  immigration  to  raise  wages  in  the  United  States. 


CHAPTER  XI 

INCREASE  IN  OUTPUT  AND  COST  OF  PRODUCTION 

A  very  important  topic  closely  connected  with  the  one  which  has 
occupied  the  last  two  chapters  is  the  effect  on  cost  of  production 
caused  by  attempts  to  increase  the  volume  of  output.  This  problem 
really  breaks  into  two  parts :  ( i )  what  will  be  the  effect  on  cost 
of  trying  to  increase  output  from  a  particular  instrument  or  group 
of  instruments  fixed  in  amount,  and  (2)  what  will  be  the  effect 
on  cost  of  trying  to  increase  the  output  from  a  particular  industry 
as  a  whole,  with  no  restriction  on  the  quantity  of  any  instrument 
or  factor.  We  begin  with  the  former  of  these  problems. 


The  Effect  on  Cost  of  Trying  to  Increase  Output  from  a  Partic- 
ular Instrument  or  Set  of  Instruments  Fixed  in  Amount 

Interpreted  as  asking  what  will  be  the  effect  on  cost  of  trying  to 
increase  output  from  a  single  instrument  or  set  of  instruments 
fixed  in  amount,  our  new  problem  is  very  close  to  that  treated  in 
Chapter  IX.  In  fact,  if  we  mean  by  cost  only  the  expenditure  for 
the  factor  which  increases,  the  two  problems  are  one,  looked  at  from 
slightly  different  points  of  view.  Under  the  conditions  named,  to 
say  that  a  plant  or  a  business  is  in  the  condition  of  diminishing 
returns  would  amount  to  the  same  thing  as  to  say  that  it  is  in  the 
condition  of  increasing  cost.  But,  in  actual  business,  we  have 
usually  no  interest  in  particular  factors  unless  they  are  economic 
ones,  that  is,  unless  they  are  factors  having  prices.  We  have, 
therefore,  to  remember  that  in  the  real  world  we  shall  have  to  pay 
for  N's  as  well  as  for  L's.  The  total  cost,  therefore,  will  not  change 
merely  with  the  change  in  output  as  measured  in  L's;  it  is  bound 
to  be  influenced  by  the  changes  in  output  as  measured  in  N's  also. 

146 


XI]  OUTPUT  AND  COST  147 

But,  though  different,  the  two  problems  are  very  closely  connected ; 
and  the  solution  of  the  one  treated  in  Chapter  IX  plays  a  large  part 
in  the  solution  of  the  new  one. 

Our  first  task  is  to  consider  the  effect  on  cost  of  trying  to  in- 
crease output  from  simple  combinations  like  those  made  up  of  our 
N's  and  L's.  The  solution  is  not  difficult,  though  the  explanation 
must  be  followed  with  some  care.  First,  the  cost  per  unit  of  product 
for  any  particular  combination  must  equal  the  cost  per  unit  measured 
in  N's  plus  the  cost  per  unit  measured  in  L's.  For  example,  if  in 
a  given  combination  the  average  output  measured  in  N's  is  10  units 
and  each  N  costs  $i,  so  that  the  cost  of  each  unit  measured  in  N's  is 
$i  over  10  or  10  cents,  and,  if  that  same  output  measured  in  L's  gives 
20  units  per  each  L  while  each  L  costs  $i,  so  that  the  cost  of 
each  unit  of  product  measured  in  L's  is  $i  over  20  or  5  cents,  then, 
the  total  cost  of  each  unit  of  product  must  be  10  cents  plus  5  cents, 
or  15  cents. 

Secondly,  the  cost  per  unit  measured  in  either  N's  or  L's  must 
increase  as  the  average  output  measured  in  that  factor  diminishes, 
and  must  diminish  as  the  average  measured  in  that  factor  increases. 
For  example,  if  the  average  output  in  N's  increases  from  10  to  20 
units,  when  each  N  costs  $i,  then  the  cost  per  unit,  measured  in  N's, 
falls  from  10  cents  to  5  cents.  On  the  other  hand,  if  the  average 
measured  in  N's  diminishes  from  20  to  10,  the  cost  of  each  N  being 
$i,  the  average  cost,  measured  in  N's,  rises  from  5  cents  to  10  cents. 

Cost  Measured  in  Each  Factor.- — Again,  since  the  average 
measured  in  N's  is  increasing  from  the  second  combination  to  the 
nineteenth,  while  that  average  diminishes  from  the  twentieth  on, 
the  cost,  measured  in  N's,  must  decline  from  the  second  to  the  nine- 
teenth combination  and  must  increase  from  the  twentieth  on.  On 
the  other  hand,  since  the  average,  measured  in  L's,  increases  up  to 
the  ninth  combination  and  then  diminishes  to  the  end,  the  cost, 
measured  in  L's,  must  diminish  up  to  the  ninth  combination  and 
thereafter  increase  to  the  end.  Further,  since  the  increase  in  the 
average  measured  in  N's  is  rapid  during  the  first  few  combinations 
after  the  ninth,  and  becomes  slow  as  we  approach  combination  19, 
the  cost  in  N's  declines  rapidly  during  the  earlier  combinations  after 


I4g  PRINCIPLES  OF  ECONOMICS  [XI 

the  ninth  and  slowly  during  the  later  ones.  In  like  manner,  the  cost 
in  L's,  though  increasing  up  to  the  nineteenth  combination,  does  this 
slowly  during  the  earlier  combinations  after  9,  speeding  up  as  we 
approach  the  turning  point  at  19. 

Cost  Measured  in  Both  Factors. — The  last  two  paragraphs 
have  shown  us  the  course  followed  by  the  cost  of  production  as 
measured  in  one  or  the  other  of  the  factors  taken  separately.  It  is 
now  easy  to  see  how  the  total  cost  per  unit,  that  is,  the  cost  measured 
in  both  factors  must  behave.  Since  cost,  measured  in  either  factor, 
diminishes  up  to  the  ninth  combination,  the  average  of  the  total  cost 
must  diminish  up  to  that  same  combination.  Again,  since  the  average 
cost,  measured  in  either  factor,  increases  after  the  nineteenth,  the 
average  of  the  total  cost  must  increase  after  the  nineteenth.  This 
statement  disposes  of  the  first  and  last  8  combinations.  What,  now, 
is  to  be  said  with  respect  to  the  remaining  1 1  ?  First,  in  so  far  as 
the  cost  for  any  one  of  these  is  influenced  by  the  cost  measured  in 
N's,  that  cost  will  tend  to  diminish  clear  up  to  the  nineteenth  com- 
bination, since  the  cost  measured  in  N's  diminishes  up  to  that  com- 
bination. 

On  the  other  hand,  in  so  far  as  the  average  of  the  total  cost 
is  being  influenced  by  the  cost  measured  in  L's,  it  will  tend  to 
increase  from  the  ninth  combination  on,  since  the  cost  measured  in 
L's  increases  from  that  point.  That  is,  we  have  here  two  opposing 
tendencies,  a  downward  one  due  to  the  influence  of  N's  and  an 
upward  one  due  to  that  of  L's. 

But,  again,  the  opposing  pulls  of  N's  and  L's  are  not  uniform 
throughout  their  course.1  Instead,  the  upward  pull  on  costs  exer- 
cised by  L's  is  relatively  small  in  the  earlier  combinations  after 
9,  but  rapidly  increases  as  we  approach  19.  So  likewise,  the  down- 
ward pull  of  N's  is  great  in  the  earlier  combinations  after  9  but 
weakens  as  we  approach  combination  19.  From  these  facts  it 
follows  that  the  general  trend  of  the  total  average  is  downward 
during  the  earlier  combinations,  upward  during  the  later  ones.  But, 


1  If  they  were,  the  resultant  tendency  might  be  a  constant  cost  between  the 
ninth  and  nineteenth  combinations,  or  it  might  be  a  least  cost  at  the  ninth 
or  a  least  cost  at  the  nineteenth. 


XI]  OUTPUT  AND  COST  149 

since  there  must  be  a  turning-point  between  these  two  opposite 
trends,  one  or  at  most  two  2  of  the  combinations  must  show  a  lower 
cost  than  the  others,  a  least  cost.  In  short,  for  any  particular  pair 
of  prices  for  N's  and  L's,  we  are  bound  to  have  results  like  this : 
( i )  during  a  shorter  or  longer  series  of  combinations,  cost  will  de- 
cline; then  (2)  a  least-cost  combination3  will  appear;  and  (3)  dur- 
ing a  longer  or  shorter  series,  cost  will  increase. 

The  Least-Cost  Combination. — What,  now,  is  to  be  said  with 
respect  to  the  location  of  the  least-cost  combination?  In  general, 
this  must  depend  on  the  relative  prices  of  N's  and  L's.  As  we  have 
already  seen,  the  influence  of  N's  must  tend  to  lower  cost  with 
every  movement  toward  combination  19,  while  the  influence  of  L's 
must  tend  to  lower  cost  with  every  movement  from  19  toward 
9.  It  follows  that  the  least-cost  point  will  tend  to  move  toward 
19  under  the  influence  of  N's  and  toward  9  under  the  influence 
of  L's. 

Which  of  these  opposing  forces  will  outweigh  the  other  depends 
upon  their  relative  magnitude,  that  is,  the  relative  magnitude  of  the 
prices  which  the  producer  has  to  pay  for  N's  and  L's.  If  N's  are 
very  costly,  this  will  tend  to  push  the  least-cost  point  toward  the 
nineteenth  combination,  and  vice  versa.  If,  for  example,  N's  cost 
$i  each  and  L's  40  cents  each,  the  seventeenth  combination  will  be 
the  cheapest;  while,  if  N's  cost  20  cents  and  L's  $i,  the  eleventh 
combination  will  occupy  this  place. 

Least  Cost  and  Diminishing  Returns. — The  foregoing  dis- 
cussion would  seem  to  clear  up  pretty  fully  the  problem  of  cost 
as  affected  by  changes  in  combining  proportions.  Before  going  on, 
however,  we  ought,  perhaps,  to  contrast  this  problem  of  changing 
costs  with  that  of  changes  in  output  as  affected  by  changes  in  com- 
bining proportions.  As  we  have  seen,  the  principle  that  output  tends 


2  When,  through  the  falling  of  the  price  of  L's,  the  point  of  least  cost 
is  about  to  pass   from   one  combination   to   the   next   lower,   one  particular 
price  for  L's  will  make  cost  in  the  two  combinations  just  the  same,  though 
a  slight  decline  in  that  price  would  move  that  point  into  the  later  combina- 
tion and  a  slight  advance  would  put  it  back  into  the  earlier  one. 

3  Or  pair  of  combinations. 


!5o  PRINCIPLES  OF  ECONOMICS  [XI 

to  increase  less  than  proportionally  is  the  same  as  the  proposition 
that  cost  tends  to  increase,  only  on  condition  that  we  are  measuring 
cost  in  the  changing  factor.  This  point,  brought  out  more  sharply 
now  that  we  are  clear  as  to  the  hehavior  of  total  cost,  means  that 
the  turning-point  from  the  preceding  stage  to  the  one  under  con- 
sideration occurs  in  a  different  combination  in  the  two  cases.  For 
example,  in  our  series  of  supposed  combinations,  the  output  is  in- 
creasing more  than  proportionally  up  to  combination  9,  after  which 
it  increases  as  far  as  combination  19  less  than  proportionally;  that 
is,  for  output,  the  ninth  combination  is  the  turning-point.  As  we 
have  just  seen,  however,  the  turning-point  for  cost  is  practically 
always  a  combination  later  than  the  ninth.  If  we  suppose  the  price 
of  each  of  the  factors  to  be  just  $i,  the  turning-point,  the  least-cost 
combination,  proves  to  be  combination  14.  Further,  as  was  fully 
explained,  this  turning-point  varies  with  every  considerable  change 
in  the  relative  prices  of  the  two  factors.  In  short,  instead  of  being 
at  the  same  combination  as  the  one  at  which  diminishing  returns 
sets  in,  it  almost  never  occupies  this  place,  and  it  may  theoretically 
be  in  any  one  of  the  n  combinations  from  the  ninth  to  the  nine- 
teenth, inclusive.  This  point  needs  some  emphasis,  because  not  a 
few  writers  have  carelessly  identified  the  principle  that,  after  a 
certain  point,  the  proportional  returns  diminish,  with  the  principle 
that,  after  a  certain  combination  is  reached,  cost  of  production  begins 
to  increase. 

We  may  add,  as  an  application  of  the  distinction  between  these 
two  principles  that  in  any  particular  case  of  the  utilization  of  a  factor 
of  production,  we  may  have  passed  the  point  of  diminishing  returns 
and  yet  not  have  reached  the  point  of  increasing  cost.  For  example, 
if  our  N's  represent  a  furnace  used  in  the  heating  of  a  house,  and 
if  the  combination  which  gave  out  the  largest  amount  of  heat  per 
unit  of  cost  was  the  I3th,  then,  if  we  were  actually  using  the  furnace 
in  the  nth,  we  should  be  using  it  in  a  stage  earlier  than  the  least- 
cost  stage,  but  not  earlier  than  the  diminishing-return  stage.  If, 
however,  the  day  was  very  mild  and  we  were  using  the  furnace  in 
the  seventh  combination,  we  should,  be  working  it  in  a  stage 
which  was  earlier  than  the  diminishing-return  one  as  well  as  earlier 
than  the  least-cost  one. 


XI]  OUTPUT  AND  COST  151 

ILLUSTRATIVE  PROBLEM 

It  is  possible  to  be  using  a  railroad  plant  in  such  a  condition  that,  if 
we  could  increase  the  traffic  a  certain  amount,  we  could  increase  the  re- 
turn per  unit  of  the  assisting  factors,  and  so  diminish  the  cost.  But  we 
might  also  be  working  that  plant  under  such  conditions  that,  though  we 
could  no  longer  increase  the  return  per  unit  by  increasing  traffic,  we 
could,  after  all,  diminish  the  cost  of  production. 

Explain  how  this  could  be. 

Least  Cost  Seldom  Realized. — One  other  point  needs  a 
moment's  comment  before  leaving  this  matter  of  least  cost.  At  first 
thought  we  might  suppose  that,  in  using  any  group  of  factors,  we 
should  always  put  them  together  in  the  proportions  giving  the  least- 
cost  combination.  'As  a  matter  of  fact,  however,  we  should  rather 
seldom  be  able  to  do  this.  In  almost  all  situations  we  have  a  body 
of  factors  which  are  relatively  fixed  over  against  a  set  which  are 
constantly  changing  in  quantity,  the  former  being  designated  fixed 
capital,  the  latter  circulating  capital.4  Now,  in  the  nature  of  things, 
the  former  cannot  be  nicely  adjusted  to  every  change  in  the  volume 
of  output.  Any  plant  will  naturally  be  planned  and  built  on  such 
a  scale  that,  when  supplying  its  normal  output,  it  will  be  working 
in  the  least-cost  combination.5  But  when  a  volume  of  output  smaller 
or  greater  than  this  is  temporarily  called  for,  it  will  become  neces- 
sary to  work  the  plant  in  a  combination  earlier  or  later  than  the 
least-cost  one.  That  is,  it  may  be  necessary  and  proper,  much  of  the 
time,  to  be  working  a  plant  in  the  diminishing-cost  stage  or  the  in- 
creasing-cost stage,  rather  than  in  the  least-cost  stage.  This  of 
course  requires  that  the  price  of  the  product  should  be  high  enough 
to  justify  the  producer  in  using  a  combination  more  expensive  than 
the  least-cost  one. 


*  Costs  growing  out  of  fixed  capital  are  often  called  overhead  costs,  those 
connected  with  circulating  capital  are  called  prime  or  out-of-pocket 
costs. 

6  This  statement  needs  qualification  because  of  the  fact  that  it  will  usually 
be  thought  best  to  plan  for  future  groivth  of  demand ;  so  that  the  plant 
will  more  usually  be  built  on  such  a  scale  that,  for  a  time,  it  will  normally  be 
working  in  a  stage  somewhat  earlier  than  the  least-cost  stage. 


I52  PRINCIPLES  OF  ECONOMICS  [XI 

What  has  been  said  of  a  plant  can  with  equal  truth  be  said  of  a 
business  unit  as  a  whole.  Here,  as  before,  the  plant  or  group  of 
plants  run  by  the  concern  will  sometimes  be  working  in  a  stage 
earlier  than  the  least-cost  combination,  or  just  at  that  combination, 
or  later, — in  the  first  case,  being  in  the  condition  of  diminishing  cost, 
in  the  second  and  third  cases  being  in  the  condition  of  increasing 
cost.  In  addition,  similar  statements  may  be  true  with  respect  to  the 
organization  side  of  the  business  unit  or  company.  The  force  of 
general  officers,  and  of  departmental  superintendents,  may  be  work- 
ing in  a  condition  of  diminishing  cost  or  one  of  increasing  cost. 
[  Finally,  it  would  seem  that  the  propositions  which  have  been 
laid  down  with  respect  to  single  instruments,  plants,  and  business 
units,  may  be  affirmed  with  respect  to  social  groups,  districts,  coun- 
tries, even  the  world.  Broadly  speaking,  any  one  of  these  totalities 
may  at  any  moment  be  in  such  a  condition  that  an  effort -to  increase 
the  aggregate  of  economic  goods  in  order  to  satisfy  the  needs  of  a 
larger  population  would  result  in  a  diminishing  expenditure  of 
human  effort  and  natural  resources,  or  just  the  reverse.  In  the 
former  case,  the  community  under  consideration  would  not  have 
carried  the  utilization  of  its  outfit  of  natural  resources  to  the  least- 
cost  combination,  though  it  might  have  carried  that  utilization  be- 
yond the  point  of  diminishing  returns.  And  an  increase  in  popula- 
tion calling  for  a  larger  output  of  products  and  furnishing  a  larger 
supply  of  human  productive  power  would  enable  the  community 
to  carry  the  utilization  of  its  natural  resources  into  a  less  costly 
and  so  more  desirable  stage.  If,  however,  the  community  had 
already  reached  or  even  passed  beyond  the  least-cost  stage,  the  in- 
crease in  population  could  only  result  in  driving  the  industry  into, 
or  further  into,  the  stage  of  increasing  cost,  and  so,  from  our  present 
point  of  view,  could  only  result  in  harm. 

ILLUSTRATIVE  PROBLEMS 

i.  If  the  demand  for  a  certain  manufactured  commodity  is  very 
small  indeed,  the  cost  per  unit  is  likely  to  be  larger  than  it  might  be.  If 
the  demand  for  that  commodity  becomes  enormously  great,  the  cost  is 
again  likely  to  be  larger  than  it  might  be.  Explain  how  both  these  state- 
ments can  be  true. 


XI]  OUTPUT  AND  COST  153 

2.     "I  am  disposed  to  think  that,  up  to  1900  anyhow,  the  United  States 
was  under-  rather  than  over-populated.'' 
Explain  how. this  could  be. 

II 

The  Effect  on  Cost  of  Trying  to  Increase  the  Output  from  an 

Industry  as  a  Whole,  There  Being  No  Restriction  on 

the  Quantity  of  Any  Instrument  Used 

We  now  pass  to  the  second  phase  of  our  problem — the  effect 
on  cost  of  trying  to  increase  the  output  from  an  industry  as  a  whole. 
What  will  happen  to  cost,  if  we  try  to  get  more  copper  from  the 
copper  industry,  or  more  wheat  from  the  wheat  industry,  or  more 
automobiles  from  the  automobile  industry?  Will  the  cost  per  unit 
remain  the  same  as  before  or  become  larger  or  smaller  than  before? 
This  question,  like  our  original  one,  breaks  into  two.  (i)  What 
will  be  the  immediate  effect  on  cost  in  a  given  case?  In  other 
words,  in  what  stage  is  an  industry  at  this  moment,  diminishing 
cost,  constant  cost,  or  increasing  cost?  (2)  What  will  normally 
be  the  effect  in  a  given  industry?  What  effect  is  characteristic  of 
that  industry?  In  which  of  the  three  stages  is  that  industry  likely 
to  be  most  of  the  time? 

Theory  of  Cost  Variation. — In  order  to  answer  these  ques- 
tions even  briefly,  we  need  to  have  in  mind  the  principal  causes 
which  tend  to  affect  the  cost  of  production  as  output  is  increased. 
Of  these  there  are  three.  The  first  cause  to  be  considered  is  the 
condition  of  the  durable  instruments  already  being  used  in  the  in- 
dustry in  question.  Are  those  instruments  being  worked  in  the 
stage  of  diminishing  cost,  or  minimum  cost,  or  increasing  cost? 
Their  condition  in  this  respect,  in  so  far  as  they  are  able  to  influence 
the  matter  at  all,  will  obviously  tend  to  establish  a  like  condition 
for  the  industry  as  a  whole.  A  second  cause  affecting  cost  is  the 
degree  of  difficulty  experienced  in  duplicating  the  instruments  em- 
ployed in  an  industry.  Will  the  new  machines,  the  new  labor,  and 
the  new  land  needed  to  expand  output  cost  the  same  as,  or  more 
or  less  than,  our  present  stock  cost  us?  The  third  cause  is  the  degree 


I54  PRINCIPLES  OF  ECONOMICS  [XI 

to  which  the  industry  is  able  to  realize  the  advantages  of  large-scale 
production  set  forth  in  an  earlier  chapter.  The  possibility  of  using 
large-scale  methods  must  of  course  tend  to  put  the  industry  into  the 
condition  of  diminishing  cost ;  and  the  extent  to  which  these  methods 
can  be  used  must  determine  largely  how  potent  they  will  prove. 

Now,  when  we  ask  concerning  the  immediate  condition  of  an  in- 
dustry, the  potency  of  these  three  causes  above  enumerated  depends 
chiefly  on  two  considerations:  (i)  the  state  of  industry  in  general, 
and  (2)  the  nature  of  the  particular  industry  involved. 

First,  to  begin  with  the  former  of  these  two  considerations,  any 
particular  industry  is  likely  to  be  in  the  condition  of  diminishing  cost 
when  business  is  depressed,  in  that  of  increasing  cost  when  business 
is  booming,  and  in  that  of  constant  cost  when  business  is  in  a  state 
lying  between  these  extremes.  The  reasons  are  evident.  The  de- 
pression means  that  demand  for  products  is  small  and  prices  are  low. 
In  consequence,  an  attempt  to  increase  output  in  response  to  increas- 
ing demand  would  find  the  situation  advantageous  in  respect  to  each 
of  the  three  causes  enumerated  above.  First,  the  fixed  capital  of  the 
industry  would  be  working  in  a  condition  of  low  efficiency  or  high 
cost,  and  the  expansion  of  output  would  enable  producers  to  utilize 
that  fixed  capital  in  a  more  efficient,  less  costly  stage.  Again,  the  low 
prices  of  a  period  of  depression  would  make  the  factors  necessary  for 
expansion  more  than  ordinarily  cheap.  Finally,  the  increase  in  out- 
put would  open  the  way  for  a  fuller  utilization  of  large-scale  methods. 
All  this  would  obviously  be  reversed  at  the  height  of  a  boom.  Fixed 
capital  would  be  working  beyond  the  point  of  highest  efficiency;  the 
cost  of  factors  would  be  very  high ;  the  advantages  of  large-scale 
methods  would  already  have  been  utilized  to  the  full.  Finally,  in  the 
period  between  these  extremes,  these  opposing  tendencies  would 
come  to  something  like  an  equilibrium  in  which  expansion  of  output 
brought  neither  less  nor  greater  but  the  same  cost. 

But,  again,  the  effects  produced  by  our  three  causes  would  be  in- 
fluenced by  the  nature  of  the  industry  in  question.  The  influence  of 
the  possibility  of  getting  more  services  out  of  fixed  capital,  of  carry- 
ing that  capital  forward  to  the  point  of  minimum  cost,  would  signify 
little  in  the  case  of  an  industry  which  used  little  of  this  type  of  capital, 
— say  retail  trade — but  much  in  an  industry  such  as  mines  and  steel 


XI]  OUTPUT  AND  COST  155 

mills,  which  used  a  great  deal.  Similar  differences  would  show  in 
the  influence  exerted  by  the  cost  of  the  factors  necessary  to  expan- 
sion. The  industries  utilizing  a  large  amount  of  fixed  capital  and 
a  relatively  small  amount  of  new  factors  would  naturally  be  less 
affected  by  the  increase  in  cost  of  the  latter.  The  smaller  the  out-of- 
pocket  expenses,  the  smaller  the  significance  of  this  element.  Thus, 
farming  is  not  affected  as  favorably  as  many  other  lines  of  industry 
by  the  low  prices  of  supplies  prevailing  in  a  period  of  depression  nor 
as  unfavorably  by  the  high  prices  of  those  supplies  characteristic  of 
the  top  of  a  boom.  Finally,  the  power  to  utilize  the  advantages  of 
large-scale  production  varies  greatly  in  different  industries.  In  farm- 
ing, for  example,  that  power  is  proverbially  low.  The  necessary 
operations  are  very  diversified  and  there  is  little  repetition  of  opera- 
tions which  duplicate  one  another;  the  fundamental  factor  in  this 
industry,  the  land,  is  also  diverse  in  character,  one  part  of  a  farm 
being  fit  for  one  purpose  and  another  fit  for  another  purpose;  and, 
finally,  the  necessity  for  rotation  of  crops  compels  frequent  changes 
in  product  and  method.  All  these  causes,  taken  together,  make  high 
specialization  in  agriculture  imprudent  where  it  is  not  impossible. 
Accordingly  this  industry  and  others  of  a  similar  kind  are  less  in- 
fluenced in  respect  to  costs  by  the  general  business  situation.  Their 
variation  in  cost  as  output  expands  is  less  considerable  than  in  the 
other  cases. 

Characteristic  Tendency. — The  foregoing  discussion  has  in  a 
large  measure  anticipated  what  we  need  to  say  concerning  our  second 
question  :  what  is  the  normal  tendency  of  cost  in  a  particular  industry 
as  output  is  expanded,  or  what  tendency  is  characteristic  of  that  in- 
dustry? The  answer  manifestly  has  little  relation  to  temporary  busi- 
ness conditions,  being  almost  entirely  a  matter  of  the  nature  of  the 
business  itself. 

The  significance  of  the  first  of  our  three  causes — the  condition 
of  the  durable  instruments  already  being  used  in  the  industry  under 
consideration — is  obviously  dependent  on  the  extent  to  which  such 
instruments  are  commonly  employed  in  that  industry.  As  compared 
with  railway  transportation,  farming  makes  relatively  small  use  of 
durable  instruments, — fixed  capital.  Naturally,  then,  the  presence 


I56  PRINCIPLES  OF  ECONOMICS  [XI 

of  unused  capacities  in  its  durable  instruments  will  be  of  much  less 
potency  to  hinder  farming  from  being  in  the  condition  of  increasing 
cost,  than  it  would  be  to  keep  railway  transportation  out  of  that  con- 
dition. This  cause,  however,  is  apparently  less  effective  in  fixing  the 
character  of  an  industry  than  the  next  one  to  be  mentioned. 

As  respects  the  influence  of  the  second  cause — the  difficulty  ex- 
perienced in  duplicating  instruments — this  naturally  turns  on  the  ex- 
tent to  which  the  industry  in  question  is  dependent  on  natural  factors. 
Those  factors  are  absolutely  limited  in  amount,  instead  of  being  sus- 
ceptible of  increase  like  capital  and  labor  services.  If,  then,  they  form 
a  very  large  part  of  the  necessary  equipment  of  a  given  industry,  for 
example,  stock-raising,  that  industry  will  naturally  pass  into  the  con- 
dition of  increasing  cost  sooner  than  one  of  which  this  is  not  true, 
for  example,  the  manufacture  of  textiles.  It  follows  from  the  above 
considerations  that  the  extractive  and  agricultural  industries  are  much 
more  likely  to  be  in  the  condition  of  increasing  cost  than  manufacture 
of  commerce.  The  narrower  the  field  from  which  the  natural  factors 
can  be  drawn,  the  greater  force  will  this  cause  exert.  It  will  be  felt 
much  more  in  the  producing  of  citrous  fruit  than  in  the  producing  of 
wheat  and  potatoes ;  more  in  platinum  mining  than  in  copper  mining ; 
more  in  copper  mining  than  in  iron  mining. 

Finally,  as  to  the  influence  of  the  third  cause,  an  industry  that 
consists  largely  of  many  similar  or  identical  operations,  and  can 
therefore  apply  methods  of  large-scale  production,  will  tend  to  be  in 
a  condition  of  constant  cost,  or  even  of  diminishing  cost.  Manu- 
factures are  conspicuously  of  this  type,  and  agriculture*conspicu- 
ously  not. 

Looking  back  over  this  discussion,  we  see  that  all  the  different 
causes  combine  to  hinder  manufacturing  from  being  in  the  condition 
of  increasing  cost,  and  to  keep  it  in  a  condition  of  constant  or  dimin- 
ishing cost.  The  manufacturing  plant  ordinarily  has  a  large  store  of 
unused  utilities;  it  depends  relatively  little  on  natural  resources; 
and  it  is  well  adapted  for  the  employment  of  large-scale  methods.  On 
the  other  hand,  agriculture  tends  just  as  strongly,  under  the  influence 
of  all  these  causes,  to  be  in  a  condition  of  increasing  cost.  It  will 
seldom  have  any  great  volume  of  unused  utilities  to  put  it  into  the 
condition  of  diminishing  cost ;  the  natural  factors  play  a  large  part 


XI]  OUTPUT  AND  COST  157 

in  its  operation ;  and  the  chance  of  employing  large-scale  methods 
is  very  slight.  In  the  mining  or  extractive  industries  the  result  is 
much  the  same  although  the  operation  of  the  different  causes  is  a 
little  different.  The  mining  industries  make  extensive  use  of  fixed 
capital,  hoisting  machinery,  machinery  for  crushing  the  rocks,  facili- 
ties for  transportation,  etc.  On  this  score  we  might  be  led  to  think 
of  these  industries  as  diminishing-cost  industries  or  even  constant- 
cost.  And  in  fact  when  a  new  grade  of  mine  has  become  available  by 
a  rise  in  price  the  industry  is  likely  to  be  temporarily  in  the  condition 
of  constant  cost.  That  is,  it  will  be  possible  for  a  time  to  expand 
output  far  beyond  the  expansion  of  demand  without  any  new  increase 
in  cost.  This  particular  element,  mining  has  in  common  with  manu- 
facture. Nevertheless,  the  former  industry  naturally  shows  in  gen- 
eral the  same  tendency  as  agriculture  because  of  the  influence  of 
the  second  cause  which  we  originally  named.  That  is,  the  dependence 
upon  natural  factors  is  so  great  that  the  relative  difficulty  of  obtain- 
ing these  factors  in  the  productive  process  offsets  the  advantage  de- 
rived from  the  former  element. 

We  have  just  seen  that  the  prevailing  or  normal  tendency  of  the 
extractive  and  agricultural  industries  is  to  be  in  the  condition  of  in- 
creasing cost;  while  that  of  the  manufacturing  industries  is  to  be 
in  the  condition  of  constant  cost.  Not  unnaturally  economists  are 
wont  to  classify  the  former  as  increasing-cost ,  the  latter  as  constant- 
cost,  industries.  Further,  as  will  appear  in  a  later  connection,  this 
distinction  among  industries  is  of  great  importance  in  connection 
with  the  determining  of  price.  A  firm  grasp  upon  the  distinction  is 
therefore  of  much  importance.  Remember,  however,  that  in  using 
this  classification  the  economist  does  not  mean  to  imply  that  an  in- 
dustry of  either  type  is  always  and  necessarily  in  the  class  indicated, 
but  only  that  this  is,  in  general,  its  proper  classification.  At  times, 
it  may  be  temporarily  in  the  other  class. 

Summary. — Summarizing  the  chief  results  of  the  preceding 
discussion  we  may  set  forth  in  conclusion  the  following  propositions : 

( i )  Any  industry  may  be  at  some  time  or  other  in  each  one  of 
these  three  stages :  diminishing  cost,  constant  cost,  and  increasing 
cost. 


158  PRINCIPLES  OF  ECONOMICS  [XI 

(2)  Most  industries  are  likely  to  be  in  the  condition  of  dimin- 
ishing cost  if  the  demand  for  their  product  is  so  small -that  an  increase 
in  that  demand  would  enable  the  industry  to  pass  from  small-scale 
to  large-scale  methods. 

(3)  Most  industries  may  be  for  considerable  periods  in  the  con- 
dition of  constant  cost  whether  their  general  classification  is  in  dimin- 
ishing cost  or  increasing  cost,  because  of  the  fact  that  at  any  particu- 
lar level  of  cost  there  is  possible  an  increase  in  output  which  is  very 
large  as  compared  with  the  expansion  of  demand. 

(4)  Practically  all  industries  must  some  time  reach  the  stage 
of  increasing  cost. 

(5)  In  general  the  agricultural  and  extractive  industries  natur- 
ally classify  as  increasing-cost  industries. 

(6)  In  general  manufacturing  industries  classify  as  constant- 
cost  industries. 

ILLUSTRATIVE  PROBLEMS 

1.  "Taken  by  and  large,  the  mining  of  copper  is  probably  an  increas- 
ing-cost industry."     Defend  that  statement. 

2.  Argue    for  the   reasonableness   of   the   proposition   that,   if   the 
marginal  cost  of  producing  copper  should  rise  from,  say,  20  to  25  cents 
per  pound,  at  the  latter  figure  this  industry  would  probably  be  for  a 
time  a  constant-cost  industry. 

3.  Give  some  reasons  for  believing  that  railway  transportation  is 
likely  to  be  much  of  the  time  in  the  condition  of  diminishing  cost. 

4.  An   industry   like  the   making   of   surgical    instruments   is   likely 
to  be  in  what  condition  as  respects  the  relation  between  cost  and  volume 
of  output?     Explain. 

5.  Suppose  that,  while  competition  in  the  industry  is  still  maintained, 
the  conditions  of  production  for  a  particular  type  of  wooden  chair  are 
such  that,  if  fewer  than  1,000  chairs  a  year  are  produced,  the  cost  per 
chair  will  be  about  $3;  that,  if  output  is  between  1,000  and  20,000,  cost 
will  be  about  $2 ;  that  if  it  is  between  20,000  and  50,000,  cost  will  be 
$i ;  if  between  50,000  and  500,000,  50  cents;  if  between  500,000  and 
2  millions,  30  cents;  if  between  2  millions  and  3  millions,  40  cents;  if 
between  3  and  4  millions,  55  cents;  if  between  4  and  5  millions,  75  cents; 
if  between  5  and  6  millions,  $1.25;  and  so  on. 


XI]  OUTPUT  AND  COST  159 

(a)  Suppose  that  in  the  year  1918,  700,000  of  these  chairs  are  pro- 
duced; that  by  1920  the  output  has  increased  to  1,300,000;  that  by  1925 
the  amount  is  1,600,000;  and  that  by  1940  it  is  1,800,000.     To  what  class 
of  goods  would  these  chairs  belong  during  the  period  of   1918  to  1940, 
looked  at  as  a  whole? 

(b)  Suppose  that  between  1950  and  2000  the  output  should  increase 
from  2,300,000  to  6  millions.     To  what  class  of  goods  would  these  chairs 
belong  during  that  50  years,  looked  at  as  a  whole?  „ 

6.  During  the  great  boom  in  the  prices  of  farm  products  character- 
istic of  the  war  period,  farmers  who  heard  comments  by  other  classes  on 
the  point  were  wont  to  say :  "But  look  what  prices  we  have  to  pay  for 
all  sorts  of  supplies,  seed,  fertilizer,  binding  twine,  labor,  etc.  This  in- 
crease in  costs  makes  big  prices  necessary."  Criticize  that  reasoning. 


CHAPTER  XII 

MONEY  EXCHANGE 

With  the  present  chapter  we  begin  the  study  of  what  has  often 
been  treated  as  one  of  the  main  divisions  of  economics,  namely, 
Exchange,  a  division  of  our  subject  which,  broadly  interpreted,  in- 
cludes nearly  all  the  most  important  topics  of  the  science.  The 
starting  point  of  this  study  is  found  in  the  fact  already  emphasized 
in  our  first  account  of  the  present  economic  order  that,  under  that 
order,  we  obtain  the  goods  which  are  necessary  to  the  satisfying  of 
our  wants  and  which,  generally  speaking,  have  to.be  produced,  not 
by  producing  those  goods  ourselves,  but  by  devoting  ourselves  to 
producing  something  which  our  neighbors  want  and  using  these  to 
get  from  others  through  exchange  the  goods  which  we  need.  It  fol- 
lows that  exchange  is  the  very  central,  pivotal,  fact  in  our  whole 
economic  order ;  every  other  fact  and  circumstance  is  directly  or 
indirectly  affected  by  it ;  and  every  aspect  of  the  exchange  phenome- 
non may  therefore  reasonably  be  expected  to  repay  the  most  care- 
ful inquiry. 

The  most  important  topic  naturally  included  under  the  division, 
Exchange,  is  value  and  price  in  their  various  aspects,  their  nature, 
function,  the  principles  or  natural  laws  determining  them,  etc.  Our 
first  duty,  however,  will  be  to  give  some  account  of  the  more  con- 
crete side  of  exchange,  at  least  of  those  aspects  of  exchange  with 
respect  to  which  there  is  need  for  more  information  than  is  commonly 
possessed  by  the  student  when  beginning  the  study  of  economics.  Of 
these  matters,  the  first  one  taken  up  in  this  and  the  next  chapter 
following  is  the  mediation  of  exchange,  the  effecting  of  exchange 
through  a  middle  term.  From  this  standpoint  we  distinguish  two 
principal  exchange  processes:  (i)  Money  Exchange  and  (2)  Credit 
Exchange.  In  the  present  chapter  we  take  up  the  former — Money 
Exchange. 

160 


XII]  MONEY  EXCHANGE  161 

I 
The  Nature  of  Money  Exchange 

Inconveniences  of  Barter. — Although  the  facts  of  money  ex- 
change are  familiar  enough  to  everyone,  their  essential  nature  and 
the  causes  lying  back  of  them  demand  a  moment's  examination.  The 
beginnings  of  exchange,  as  found  in  primitive  societies,  have  always 
taken  the  form  of  barter — the  direct  exchanging  of  goods  for  goods. 
A  man  who  has  grain  to  spare  and  wants  a  canoe,  gets  into  communi- 
cation with  a  neighbor  who  has  canoes  to  spare  and  wants  grain,  and 
a  mutual  transfer  is  effected.  But  this  method,  even  in  the  most 
favoring  conditions,  is  highly  inconvenient.  The  man  who  has  pro- 
duced a  surplus  of  grain  which  he  wishes  to  exchange  for  a  canoe  is 
obliged  first  to  seek  out  someone  who  has  a  canoe  to  dispose  of  and 
at  the  same  time  needs  grain  and  who,  further,  needs  grain  in  an 
amount  exactly  corresponding  to  the  value  of  the  canoe. 

But  this  necessary  coincidence  between  exchangers  as  respects 
the  kinds  and  amounts  of  goods  wanted  and  offered  can  exist  but 
rarely,  and,  where  it  does  exist,  can  be  discovered  only  after  laborious 
searching.  It  would  not  be  hard  to  find  men  who  want  grain ;  but 
they  may  have  no  canoes  to  dispose  of.  So,  it  would  be  fairly  easy 
to  find  men  who  have  canoes  to  sell ;  but  they  may  not  want  grain ; 
or,  if  any  one  of  them  does  want  grain,  he  may  want  only  half  as 
much  as  would  be  needed  to  pay  for  a  canoe.  As  civilization  ad- 
vances these  obstacles  to  barter  become  more  and  more  serious. 
Occupations,  tastes,  and  incomes  grow  more  diverse,  and  a  larger 
and  larger  number  of  workers  produce  things  which,  being  unfitted 
to  satisfy  their  own  wants,  must  be  exchanged,  but  which  at  the  same 
time  are  wanted  by  only  a  few  other  individuals,  and  those  perhaps 
widely  scattered.  For  such  persons — that  is,  for  most  of  us — ex- 
changing their  own  products  directly  for  all  the  different  kinds  of 
goods  they  require  would  be  entirely  out  of  the  question.  For  a 
manufacturer  of  steel  rails  or  mowing  machines  or  microscopes  or 
surgical  implements  to  go  about  trying  to  obtain,  in  trade  for  these 
wares,  sugar  or  flour  or  a  suit  of  clothes,  would  be  not  merely  in- 
convenient but  futile. 


PRINCIPLES  OF  ECONOMICS  [XII 

Mediated  Exchange. — But  no  highly  developed  society  tries, 
or  ever  did  try  for  long,  to  conduct  its  exchange  on  the  barter  plan. 
In  the  earliest  trade  of  which  we  have  any  record,  men  were  already 
making  use  of  a  medium  of  exchange — some  go-between  which  each 
one  obtained  in  exchange  for  his  own  goods  and,  when  he  had  ob- 
tained it,  used  to  buy  other  goods.  The  exchange  medium  consists 
of  some  concrete  good  of  such  a  nature  that  we  can  readily  add  to, 
or  take  from,  the  amount  used,  so  as  to  make  up  an  amount  exactly 
equal  in  value  to  the  object  we  wish  to  buy.  With  the  assistance  of 
such  a  medium,  the  troubles  of  the  man  who  has  grain  to  dispose  of 
and  wants  a  canoe  quickly  disappear.  He  simply  sells  his  grain  to 
the  different  persons  who  want  grain,  they  giving  him  from  their 
easily  divisible  store  exactly  as  much  of  the  exchange  medium  as  the 
grain  is  worth;  and  then,  taking  to  a  canoe  maker  the  medium  thus 
obtained,  he  pays  over  as  much  of  it  as  is  necessary  to  purchase  a 

canoe. 

i 

Various  Functions  of  Money. — Exchange,  then,  is  mediated 
by  money,  and  wherever  the  money  institution  exists  its  principal 
function  is  to  serve  as  the  medium  of  exchange.  It  perhaps  ought 
to  be  remarked  in  passing,  however,  that  jiist  because  money  is  the 
medium  of  exchange,  it  almost  inevitably  takes  on  other  functions. 
It  serves,  for  one  thing,  as  a  measure  of  value.  Being  exchanged 
against  all  other  goods,  it  naturally  becomes  the  thing  in  which  the 
values  of  all  other  goods  are  computed  and  expressed.  It  sometimes 
performs  this  function  even  when  not  actually  called  upon  to  serve 
as  the  middle  term  in  exchange,  as  for  example  when  two  people 
estimate  the  value  of  their  respective  goods  in  terms  of  money,  and 
yet  proceed  to  exchange  them  directly,  barter  fashion.  In  fact,  the 
value-measuring  function  of  money  often  exists  quite  independently 
of  its  exchange  function,  and  often  seems  of  almost  equal  im- 
portance. Again,  money  or  its  equivalent,  bank  credit  (which  comes 
up  for  treatment  in  the  next  chapter),  serves  as  a  medium  of  accumu- 
lation, the  instrument  through  which  accumulations  of  capital  are 
immediately  effected.  Closely  allied  to  this  last  is  its  service  as  a  loan 
medium  since,  as  we  know,  the  man  who  borrows  capital  must  usually 
obtain  it  first  in  the  form  of  money  or  bank  credit.  Money  is  also 


XIII  MONEY  EXCHANGE  163 

utilized  as  the  legal  means  of  payment,  in  the  discharge  of  taxes, 
fines,  etc.  Finally,  in  backward  countries  it  is  much  employed,  along 
with  precious  stones,  as  a  storer  of  wealth  by  men  who,  seeking  to 
save  their  property  from  robbers  or  tyrannical  governments,  turn  it 
into  these  easily  concealed  forms.  Various  other  functions  of  money 
could  doubtless  be  distinguished  in  a  fuller  analysis.  The  central 
one,  however,  the  one  with  which  we  are  chiefly  concerned  in  this 
course,  and  hence  the  only  one  calling  for  more  than  passing  mention, 
is  to  serve  as  a  medium  of  exchange. 

In  the  earlier  forms  of  exchanging  society,  the  exchange  medium 
or  go-between  was  always  some  use-commodity,  that  is,  a  commodity 
which  people  generally  wanted  for  some  purpose  to  which  it  could  be 
put  directly,  as  for  example,  cattle,  hides,  tobacco,  lumps  of  salt,  or 
cubes  of  tea.  But,  with  the  passage  of  time  and  the  increase  of 
wealth,  people  got  in  the  way  of  using  as  their  medium  of  exchange 
something  specially  manufactured  and  set  apart  for  this  function. 
It  is  only  when  this  stage  is  reached  that  we  can  properly  talk  about 
money;  for  by  money  we  mean  an  instrument  specially  made  for, 
and  adapted  to,  the  work  of  mediating  exchange,  and  to  those  other 
tasks  naturally  performed  by  the  exchange  medium. 

For  many  centuries  after  its  introduction,  the  money  of  even  the 
most  advanced  countries  was  little  more  than  an  aggregation  of 
rather  crude  coins  of  very  few  varieties  or  sizes.  But  with  the  prog- 
ress of  industrial  society,  the  money  of  each  country  has  come  to 
constitute  an  elaborate  system  containing  many  different  kinds  of 
money  adapted  to  the  performance  of  different  functions,  and  all 
more  or  less  perfectly  co-ordinated  into  a  coherent,  self -consistent 
whole.  We  must  now  explain  the  principal  features  of  such  a 
system. 

II 

The  Monetary  System 

The  Denomination  System. — The  first  element  to  be  re- 
marked in  the  American  or  any  other  monetary  system  is  the  scale 
of  denominations,  the  names  employed  for  expressing  quantities  of 
money.  The  need  for  some  means  of  doing  this  is  easily  seen.  The 
use  of  money  to  effect  exchanges  or  measure  values  plainly  requires 


164  PRINCIPLES  OF  ECONOMICS  [XII 

that  we  should  be  able  to  express  quantities  of  money.  But  this 
means,  as  in  similar  cases,  that  we  should  have  some  unit  or  units  for 
doing  this, — some  name  or  names  which  every  one  recognizes  as 
meaning  certain  definite  quantities.  Such  names  are  commonly 
designated  "denominations."  It  would  doubtless  be  possible  to  get 
along  with  just  one  of  such  denominations;  but,  on  account  of  the 
great  differences  in  the  quantities  of  money  which  we  need  to  make 
up  for  different  purposes,  it  is  obviously  much  more  convenient  to 
have  a  variety  of  such  denominations,  ranging  from  very  small  to 
very  large  ones.  These  different  denominations  usually  differ  by 
some  convenient  ratio,  and  form  a  coherent  system  of  denominations. 
The  different  denominations  in  such  a  system  are  naturally  dis- 
tinguished as  Primary  and  Secondary.  The  primary  denomination, 
more  often  called  the  monetary  unit,  is  fundamental  in  the  system, 
the  other  denominations  being  referred  to  it  in  defining  their  quan- 
tity. The  precise  significance  of  this  statement  is  best  explained  by 
comparison  with  an  analogous  case,  the  unit  of  liquid  measure.  The 
gallon  constitutes  this  unit,  and  other  quantities  are  described  as 
fractions  or  multiples  of  a  gallon :  thus  a  quart  is  a  fourth  of  a  gallon 
and  a  pint  one-eighth  of  a  gallon;  thirty-one  and  one-half  gallons 
make  one  barrel,  and  sixty-three  gallons  (two  barrels)  makes  one 
hogshead.  Similarly,  in  the  American  monetary  system  the  unit  is 
one  dollar,  and  all  secondary  denominations  are  regarded  as  frac- 
tional parts  or  multiples  of  the  dollar.  The  cent  is  a  hundredth  of  a 
dollar,  the  dime  a  tenth  of  a  dollar,  the  twenty-five  cent  piece  a  quarter 
of  a  dollar,  the  half -eagle  five  dollars,  and  the  eagle  ten  dollars.  In 
other  countries,  these  denominations  are  different  from  the  American 
and  usually  from  those  of  any  other  nation ;  but  in  all  of  them  some 
kind  of  denomination  system  exists. 

The  Monetary  Standard. — The  second  essential  element  in  a 
monetary  system  is  the  monetary  standard.  The  special  office  of  the 
standard  is  to  fix  the  meaning  or  value  of  the  monetary  unit.  For 
purposes  of  explanation,  let  us  again  refer  to  the  analogue  of  liquid 
measure.  As  we  all  know,  there  exist  at  the  present  time  thousands 
of  liquid  containers  treated  as  gallon  measures.  Obviously  it  is  quite 
possible  that  these  should  be  unequal  in  capacity,  so  that,  if  we  were 


XII]  MONEY  EXCHANGE  165 

to  measure  a  given  amount  of  some  liquid  in  one  of  these  measures, 
we  should  get  one  result;  if  we  used  another  of  these  measures,  we 
should  get  another  result ;  and  so  on.  But  of  course  it  is  quite  im- 
portant that,  when  measuring  liquids,  we  should  use  measures  having 
the  same  capacity,  else  the  way  would  be  open  for  unlimited  error 
and  controversy.  How  is  this  brought  about?  How  do  we  insure 
that  the  gallon  shall  always  signify  the  same  thing?  Simply  by 
requiring  that  a  true  gallon  measure  shall  be  able  to  hold  a  certain 
amount,  by  weight,  of  some  one  substance,  no  more  and  no  less. 
The  standard  chosen  is  pure  water  under  prescribed  conditions  of 
temperature  and  air  pressure.  The  amount  is  8.33  pounds.  This 
fact  we  express  by  saying  that  8.33  pounds  of  pure  water  is  the 
standard  of  liquid  measure  in  the  United  States.  If  any  receptacle 
proves  upon  examination  to  hold  more  or  less  than  this  standard 
amount,  it  is  not  a  true  gallon,  and  to  make  it  so  one  must  measure 
it  something  less  than  full,  or  full  and  something  over.  Only  by 
being  equal  to  the  standard  gallon  can  it  hope  to  pass  as  a  true 
gallon  container. 

The  monetary  system  is  in  this  respect  the  same  as  that  of  liquid 
measure.  The  money  unit  is  one  dollar.  But  we  have  many  different 
kinds  of  money  in  which  a  dollar  may  be  represented,  gold  coin, 
silver  coin,  greenbacks,  bank  notes,  and  so  on.  Now,  all  these  forms 
of  the  dollar  have  very  different  degrees  of  intrinsic  value ;  the  gold 
dollar  is  worth  just  as  much  whether  it  is  coined  or  melted  into  a 
shapeless  lump ;  the  silver  piece  is  worth  as  much  as  gold  when 
coined,  but  very  much  less  when  melted;  the  paper  in  itself  is  worth 
practically  nothing.  This  being  true,  it  would  be  very  easy  for  the 
dollar  as  represented  in  different  kinds  of  money  to  have  different 
values, — the  meaning  of  the  dollar  might  change  with  every  change 
in  the  kind  of  money  used,  and  any  accurate  reckoning  or  dependable 
business  agreements  would  become  impossible.  But  here,  as  in  the 
case  of  liquid  measure,  uniformity  is  secured  by  means  of  a  standard. 
Within  the  boundaries  of  the  United  States,  in  every  conceivable 
connection  unless  otherwise  specified,  one  dollar  means  the  amount 
of  value  which  attaches  to  25.8  grains  of  gold,  nine-tenths  fine. 
This  amount  of  gold  is  known  as  the  monetary  standard,  and  accord- 
ing to  it  every  dollar  of  actual  money  is  judged.  A  true  dollar  must 


166  PRINCIPLES  OF  ECONOMICS  [XII 

contain  the  same  value  as  a  piece  of  gold  nine-tenths  fine,  weighing 
25.8  grains.  And  if  any  so-called  dollar  happens  at  any  time  to  con- 
tain more  or  less  than  this  standard  amount  of  value,  it  is  not  a  true 
dollar,  and  to  make  it  so,  something  must  be  taken  away  or  something 
added. 

ILLUSTRATIVE  PROBLEM 

From  a  conversation  in  a  barber  shop  in  the  fall  of  1919.  "One  thing 
I  can't  understand.  The  price  of  almost  everything  is  climbing;  but  the 
price  of  gold  stays  just  the  same, — always  $20.67  Per  ounce  of  pure  gold." 
Why  is  this  bound  to  be  true  as  long  as  our  money  laws  are  unchanged  ? 

The  Different  Kinds  of  Money. — We  have  explained  the 
denomination  system  and  the  standard  essential  to  any  monetary 
system.  We  must  now  distinguish  the  different  kinds  of  money  in 
which  the  denominations  anc  the  standard  are  embodied  and  comment 
on  their  several  functions. 

The  Standard  Money. — First,  we  have  the  standard  money, 
that  particular  kind  of  money  which  immediately  embodies  or  repre- 
sents the  monetary  standard.  As  already  noted,  the  standard  in  the 
United  States  is  25.8  grains  of  the  metal  gold,  nine-tenths  fine.  But 
we  do  not,  of  course,  actually  make  any  use  in  ordinary  commercial 
relations  of  the  mere  metal  gold,  unmanufactured,  in  the  form  ot 
dust  or  lumps.  Neither  do  we  have  such  a  lump  of  gold  locked  up 
at  Washington  to  act  as  a  standard  for  our  money  unit,  as  we  have 
a  platinum-iridium  bar  locked  up  in  that  city  to  act  as  a  standard 
for  units  of  length.  The  plan  we  actually  adopt  is  to  issue  one  par- 
ticular kind  of  money  called  standard  money,  which  is  kept  equal 
in  value  to  the  real  standard,  and,  jtist  as  far  as  possible,  to  keep  the 
meaning  or  value  of  the  dollar  in  every  other  kind  of  money  (as 
well  as  in  all  credit  documents,  prices,  etc.)  the  same  as  the  value  of 
this  standard  money  dollar.  In  the  American  system,  the  standard 
money  is  a  coin  made  of  the  standard  substance,  gold,  and  containing 
just  the  amount  of  that  standard  substance  which  constitutes  the 
standard.  By  devices  which  will  more  naturally  be  explained  in  a 
later  connection,  this  kind  of  coin  is  all  the  time  kept  equal  in  value 
to  the  quantity  of  gold  bullion  which  it  is  presumed  to  contain;  so 


XII]  MONEY  EXCHANGE  167 

that  it  may  be  said  to  embody  the  real  standard  supposed  to  lie  be- 
hind it. 

The  Immediate  and  the  Ultimate  Standard. — If,  as  just  ob- 
served, the  value  of  the  dollar  in  other  kinds  of  money,  in  credit  docu- 
ments, prices,  etc.,  is  kept  equal  to  the  value  of  the  standard  dollar, 
this  does  not  mean  that  the  dollar  in  these  other  relations  is  directly 
kept  equal  to  the  value  of  a  lump  of  gold  weighing  25.8  grains.  It 
is  kept  equal  to  the  value  of  the  standard  money,  gold  coin ;  and  the 
latter,  in  its  turn,  is  kept  equal  in  value  to  the  lump  of  gold.  If  by 
any  process  the  gold  coin  and  the  lump  of  gold  should  be  separated 
in  value,  the  dollar  in  other  moneys,  in  prices,  etc.,  would  follow  the 
gold  coin  rather  than  the  bullion.  This,  compels  us  to  notice  the  dis- 
tinction between  the  immediate  monetary  standard,  the  standard 
money,  and  the  standard  behind  that,  which  is  here  called  the  ultimate 
standard,  that  is,  the  lump  of  gold  which,  under  normal  conditions, 
is  the  real  determinant  of  the  value  of  the  dollar. 

In  the  American  system,  as  just  indicated,  the  standard  money, 
being  made  of  the  same  metal  and  the  same  amount  of  metal  as  that 
contained  in  the  ultimate  standard,  may  be  said  to  embody  the  ulti- 
mate standard.  This  is  also  the  plan  followed  in  most  good  monetary 
systems.  It  should  be  noted,  however,  that  such  an  arrangement  is 
not  absolutely  necessary ;  and  we  may  better  understand  the  relation 
between  standard  money  and  the  ultimate  standard  by  observing  a 
quite  different  way  in  which  substantially  the  same  end  could  be 
accomplished.  It  is  perfectly  possible,  theoretically,  to  have  a  system 
in  which  standard  money  is  made  of  some  other  substance  than  the 
one  which  holds  the  place  of  ultimate  standard.  Thus,  we  might  cut 
out  gold  coin  altogether,  issuing  paper  as  our  standard  money,  and 
yet  retain  gold  as  our  ultimate  standard,  provided  a  dollar  in  paper 
was  all  the  time  kept  equal  in  value  to  25.8  grains  of  gold,  while  the 
dollar  in  all  other  forms  was  kept  equal  to  that  particular  kind  of 
paper  money. 

The  plan  of  having  a  standard  money  which  does  not  embody 
the  ultimate  standard,  but  is  kept  at  par  by  some  special  device,  sug- 
gests various  schemes,  which  have  been  favored  from  time  to  time, 
for  improving  the  ultimate  standard.  Thus,  some  economists  believe 


168  PRINCIPLES  OF  ECONOMICS  [XII 

that,  instead  of  having  a  single  substance  as  the  standard,  we  ought 
to  use  a  large  number,  say  100  or  more,  in  order  to  avoid  too  great 
and  rapid  changes  in  the  value  of  the  standard.  A  natural  way  to 
work  out  such  a  plan  would  be  to  issue  paper  money  as  the  standard 
money,  and  set  up  devices  for  keeping  this  paper  money  equal  in 
value  to  the  list  of  goods  chosen.  Another  way  would  be  to  have 
for  our  standard  money  a  coined  money,  as  at  present,  but  to  redeem 
that  money  in  varying  amounts  of  gold,  always  larger  than  the 
amount  in  it,  and  always  so  adjusted  as  to  keep  the  value  of  the  coin 
equal  to  that  of  the  list  of  goods  originally  chosen  as  the  standard. 

ILLUSTRATIVE  PROBLEM 

Suppose  that  Congress  should  pass  a  law  making  the  money  standard 
one  one-hundredth  part  of  the  value  of  a  certain  bill  of  goods. 

(a)  When  the  scheme  was  working  as  intended,  what  would  be  the 
total  money  value  of  said  bill  of  goods? 

(b)  If  at  a  certain  time  the  bill  of  goods  proved  to  be  worth  $107, 
showing  tbat  the  money  unit  had  left  the  legal  standard,  which  way  would 
that  unit  have  gone,  up  or  down? 

(c)  Answer  the  same  question,  supposing  the  money  value  of  said 
bill  of  goods  to  be  $95. 

Functions  of  Standard  Money. — Leaving  this  study  of  the 
nature  of  standard  money,  we  must  now  add  a  word  with  respect 
to  its  functions.  The  standard  money  of  our  system,  gold  coin, 
though  to  a  limited  extent  used  as  a  medium  of  exchange  in  ordinary 
trade,  is  chiefly  confined  to  two  offices:  (i)  serving  as  the  money 
of  international  trade,  and  (2)  maintaining  the  gold  standard  by 
maintaining  the  convertibility  of  other  forms  of  money.  Standard 
money  serves  best  as  the  money  of  international  trade  because  it  has 
a  bullion  or  substance  value  as  great  as  its  nominal  value,  whereas 
other  moneys  do  not.  A  man  who  accepts  it,  therefore,  need  have 
no  misgivings  lest  he  get  less  than  he  bargained  for.  To  a  limited 
extent  international  creditors  accept  non-standard  moneys  and,  as 
we  shall  see  in  the  next  chapter,  mere  credit.  But,  in  general, 
they  must  be  paid  in  cash ;  and  that  cash  must  be  something  which  is 
worth  its  face  value.  Hence  they  demand  standard  coin,  or,  even 


XII]  MONEY  EXCHANGE  169 

better,  bullion  or  bar  gold  which  has  not  been  manufactured  into 
money  at  all. 

But,  while  gold  or  standard  money  is  needed  for  international 
trade,  in  the  domestic  exchange  of  most  countries  it  is  very  little 
used.  The  chief  function  of  gold  money  within  a  country  is  to 
maintain  the  convertibility  into  gold  of  other  kinds  of  money  and  so 
to  maintain  the  standard  of  the  system.  The  standard,  we  know,  has 
as  its  function  the  determining  of  the  meaning  or  value  of  the  mone- 
tary unit  in  all  kinds  of  money.  But  most  kinds  of  money,  other 
than  gold,  for  example,  silver  coin,  copper  coin,  bank  notes,  etc., 
have  in  themselves  as  substance  much  less  value  than  they  claim  on 
their  face.  A  silver  dollar,  as  silver,  was,  until  quite  recently,  worth 
less  than  fifty  cents ;  a  hundred  copper  cents  are  rarely  worth  more 
than  fifteen  cents;  a  paper  dollar,  as  substance,  has  no  appreciable 
value.  It  naturally  follows  that  some  effort  is  needed  to  keep  these 
different  forms  of  money  at  par  with,  or  equal  in  value  to,  standard 
money.  There  are  various  ways  of  accomplishing  this  result,  but 
none  really  certain  except  one  which  makes  it  possible  to  get  gold 
money  in  exchange  for  any  other  kind.  It  is  not  necessary  that  we 
be  able  to  exchange  other  moneys  for  gold  in  any  and  every  case, 
but  it  is  necessary  that  we  be  able  to  obtain  gold  when  we  really 
need  it, — for  example,  to  make  payments  in  other  countries, — and  that 
without  being  obliged  to  pay  a  premium  or  suffer  inconvenience  or 
delay.  If  at  any  time  when  we  greatly  needed  gold  we  could 
not  obtain  a  dollar  of  it  for  a  dollar  of  other  moneys,  those  other 
moneys  would  inevitably  cease  to  be  equal  in  value  to  the  standard 
money. 

In  concluding  this  treatment  of  standard  money,  a  word  should 
be  added  concerning  a  form  of  paper  money  which  is  virtually  equiv- 
alent to  gold  coin.  I  mean  the  gold  certificate.  This  is  a  document 
certifying  that  the  quantity  of  gold  mentioned  on  its  face  has  been 
deposited  in  the  Federal  treasury,  and  is  held  ready  to  be  delivered 
in  exchange  for  the  certificate.  The  certificate  is  thus  nothing  more 
than  a  warehouse  receipt  for  the  gold  coin  in  deposit.  As  long  as 
the  owner  only  wishes  to  hold  this  coin  as  a  reserve  or  to  use  it  in 
settlements  at  the  clearing  house,  the  certificate  is  all  he  needs,  and  is 
safer  and  easier  to  keep  and  carry  about ;  and  should  it  happen  that 


I7o  PRINCIPLES  OF  ECONOMICS  [XII 

he  really  must  have  the  gold  itself,  he  can  always  get  it  by  presenting 
the  certificate. 

Quasi-Standard  Money. — We  have  explained  the  nature  and 
functions  of  a  standard  money,  basic  money,  as  it  is  sometimes  called. 
We  must  now  comment  briefly  on  the  other  kinds  generally  present 
in  the  systems  of  our  time.  First,  it  is  not  uncommon  to  have  a 
quasi-standard  money  consisting  of  a  note  issued  by  the  government 
or  some  special  institution,  a  note  which  is  legal  tender  in  most  or 
all  relations,  and  redeemable  in  standard  money.  Such  a  money 
will  perform  most  of  the  functions  of  standard  money.  Being  di- 
rectly redeemable  in  gold,  every  one  will  receive  it  readily,  and  only 
those  who  for  some  reason  require  the  metal  itself  will  insist  on 
using  the  treasury  note  to  get  gold.  Moneys  of  this  sort,  though  not 
seldom  employed  in  everyday  circulation,  have  as  a  more  distinctive 
characteristic  the  fact  that  they  in  large  measure  constitute  the  bank 
reserves  of  the  country,  particularly  the  central  reserves.  Doubtless, 
these  reserves  ought  to  contain  a  considerable  quantity  of  gold  itself  ; 
but  the  treasury  notes  answer  almost  equally  well  so  long  as  the 
treasury  keeps  ample  gold  reserves  to  redeem  them. 

Other  Moneys. — The  remaining  moneys  to  be  found  in  any 
system  with  which  we  are  familiar  are  employed  mostly  as  ordinary 
media  of  exchange.  First  come  the  notes  of  the  national  banks  pay- 
able at  the  issuing  bank  and  also  at  the  Federal  treasury,  having  the 
status  of  legal  tender  to  all  national  banks,  and  being  receivable  for 
all  public  dues  except  import  duties.  Next  come  the  Federal  Re- 
serve bank  notes.  These  are  akin  to  the  bank  notes  just  named,  being 
issued  by  the  Federal  Reserve  banks  on  the  security  of  certain  types 
of  national  indebtedness.  They  were  a  compromise  element  in  the 
law  which  established  the  Federal  Reserve  system,  and  would  prob- 
ably have  been  of  little  moment  but  for  special  exigencies  growing 
out  of  the  late  war.  As  a  matter  of  fact,  a  large  quantity  of  them 
was  issued;  but  the  present  law  calls  for  their  later  retirement. 

A  third  type  of  ordinary  circulating  medium  is  the  Federal  Re- 
serve note  (not  bank  note),  issued  by  the  Regional  Reserve  banks 
under  the  authority  of  the  Federal  Reserve  Board.  In  form  they 


XII]  MONEY  EXCHANGE  171 

are  treasury  notes,  that  is,  they  are  promises  to  pay,  signed  by  the 
Treasurer  of  the  United  States.  But  the  regional  banks  are  re- 
quired to  assume  the  responsibility  for  them  as  if  their  own  officers 
had  made  the  signature.  These  notes  are  a  full  legal  tender.  It  was 
hoped  that  they  would  in  time  replace  all  other  notes,  and  even  silver 
certificates;  but  the  prospect  for  this  result  is  not  good. 

A  fourth  sort  of  paper  money  is  the  silver  certificate,  which,  in 
form,  is  a  warehouse  receipt  for  a  corresponding  amount  of  silver 
dollars,  but  which,  in  practice,  is  a  bill  used  for  what  has  been  called 
"large  change."  Until  recently,  the  silver  certificate  constituted  the 
major  part  of  our  everyday  medium  of  exchange;  but  it  has  been 
latterly  replaced  by  other  forms  of  paper,  especially  Federal  Reserve 
bank  notes.  Unless,  however,  some  change  is  made  in  laws  at  present 
in  force,  the  earlier  condition  of  things  is  likely  to  be  repeated.  The 
silver  certificate  is  exchangeable  only  for  silver  dollars,  but  it  is 
worth  its  face  value  in  gold  j*ust  as  if  it  were  redeemable  in  that 
metal. 

Subsidiary  Coin. — In  addition  to  the  moneys  already  enumer- 
ated, we  have  various  sorts  of  coin.  In  general,  they  are  literally  or 
virtually  subsidiary  coins,  though,  in  strict  usage,  this  designation 
is  limited  to  fractional  silver.  We  therefore  begin  with  explaining 
the  distinctive  characteristics  of  subsidiary  coins.  First,  these  coins 
are  put  out  in  small  denominations,  being  specially  intended  for 
serving  as  a  medium  of  exchange  in  minor  transactions  and  as  tools 
for  "making  change."  Again,  they  are  made  of  inferior  metal, 
metal  having  low  specific  value;  for  a  coin  of  small  denomination,  if 
made  of  valuable  metal,  would  be  too  small  for  convenience  in 
handling.  Subsidiary  coins  are  characterized  also  by  shortness  in 
weight:  they  contain  a  smaller  amount  of  metal  than  would  seem  to 
be  called  for  by  their  nominal  value.  As  a  result,  they  are  worth 
less  as  mere  pieces  of  metal  than  as  money ;  so  that,  unless  the  value 
of  the  metal  changes  greatly,  no  one  will  melt  them  for  the  sake  of 
the  metal  they  contain.  Their  circulation  is  thus  assured. 

Again,  subsidiary  coins  are  strictly  limited  in  the  amount  coined. 
They  are  issued  only  by  the  government,  and  the  issue  is  limited  to 
the  amount  which  experience  shows  is  really  needed  for  the  purpose 


I72  PRINCIPLES  OF  ECONOMICS  [XII 

of  trade.  This  policy  is  primarily  intended  to  insure  the  coins  of  this 
sort  against  falling  in  value  below  their  nominal  value;  and  it  has 
practically  always  been  successful.  So  long  as  the  needs  of  business 
keep  subsidiary  coins  employed,  so  that  few,  if  any,  persons  find 
themselves  loaded  up  with  an  excessive  stock,  the  coins  remain  at 
par.  In  the  United  States,  this  result  is  still  more  fully  assured  by 
a  provision  that  the  United  States  treasury  shall  redeem  such  coins 
at  par  in  legal  money. 

Still  another  characteristic  of  subsidiary  coin  is  the  limitation  of 
its  legal  tender  prerogatives.  This  provision  has  two  objects.  First, 
it  is  intended .  to  hinder  any  person  from  burdening  creditors  to 
whom  he  is  making  payment  with  a  great  quantity  of  inconveniently 
heavy  coins.  Second,  it  is  intended  to  hinder  subsidiary  coins  from 
displacing  the  standing  money  already  established  and  putting  them- 
selves in  its  place, — a  thing  which  might  happen,  if  these  coins  were 
to  become  less  valuable  than  standard  money  while  still  a  full  legal 
tender.  How  this  would  be  brought  about  will  be  better  understood 
when  we  have  studied  the  principles  governing  the  monetary  standard 
given  in  Chapter  XXXII. 

A  final  characteristic  of  subsidiary  money,  not  universal,  but 
present  under  our  system,  is  redeemability.  One  purpose  of  this  pro- 
vision— to  insure  that  the  money  shall  be  kept  at  par — has  already 
been  explained,  and  needs  no  further  comment.  Another  object  is 
to  enable  persons  coming  into  possession  of  considerable  quantities 
of  this  kind  of  money  to  exchange  it  for  more  convenient  kinds. 
The  desirableness  of  such  an  opportunity  is  evident.  Business  con- 
cerns need  enough  small  coin,  but  to  be  loaded  up  with  thousands  of 
dollars  of  such  money,  when  the  public  generally  would  object  to 
accepting  it,  would  be  very  undesirable.  The  provision  that  the  gov- 
ernment shall  redeem  all  such  coin  meets  this  difficulty  completely. 

The  last  few  paragraphs  have  dealt  with  the  sort  of  coin  which  is 
universally  recognized  as  "subsidiary."  A  word  or  two  should  now 
be  devoted  to  the  varieties  not  always,  or  perhaps  usually,  counted 
in  this  class.  First,  we  have  token  money  or  billon,  consisting  of 
very  small  coins  made  of  cheap  metals,  for  example,  our  nickel  five- 
cent  pieces  and  copper  cents.  This  type  of  money  was  evolved 
earlier  than  the  coins  usually  designated  as  subsidiary.  But,  theo- 


XII]  MONEY  EXCHANGE  173 

retically,  there  is  no  good  ground  for  distinguishing  them  from  the 
latter;  they  usually  have  all  the  characteristics  above  enumerated 
for  subsidiary  coins  proper. 

The  other  money  which  is  virtually,  though  not  literally,  a  sub- 
sidiary coin  is  the  silver  dollar  already  alluded  to  on  page  172. 
This  cannot  be  strictly  described  as  a  subsidiary  coin,  because  it 
lacks  the  characteristic  of  limited  legal  tender  which  is  present  in  true 
subsidiary  coins  everywhere,  and  also  lacks  the  redeemability  of 
American  subsidiary  coins.  Furthermore,  while  the  silver  dollar  is 
not  a  full  weight  coin,  it  does  not  possess  the  characteristic  of  short- 
ness of  weight  in  so  great  a  degree  as  the  real  subsidiary  coins.  Thus 
two  half-dollars  or  four  quarters  do  not  contain  quite  as  much  metal 
as  does  one  silver  dollar.  In  effect,  however,  it  is  a  subsidiary  coin. 
It  has  most  of  the  characteristics,  and  behaves  as  if  it  had  them  all. 
Although  not  limited,  as  are  true  subsidiary  coins,  in  legal  tender 
prerogatives,  it  does  not  displace  the  standard.  And  although  not 
redeemable,  it  remains  at  par  in  spite  of  the  fact  that  its  metal  value 
is  much  below  its  face  value.  These  facts,  however,  should-  not  lead 
us  to  think  that  the  silver-dollar  situation  is  an  entirely  satisfactory 
one.  On  the  contrary,  most  specialists  are  convinced  that  the  silver 
dollar  ought  either  to  be  withdrawn  altogether,  or  frankly  and  com- 
pletely given  the  status  of  subsidiary  coins. 

ILLUSTRATIVE  PROBLEMS 

1.  Illustrate  with  concrete  examples  the  drawbacks  of  barter  as  a 
method  of  exchange. 

2.  Illustrate  the  use  of  money  as  a  measure  of  value  in  a  case  of 
barter. 

3.  In  primitive  communities  the  media  of  exchange  have  usually  been 
objects  desired  for  direct  use  and  also  objects  commonly  produced  in  the 
community.     Give  some  reason  or  reasons  for  each  of  these  facts. 

4.  During  the  first  part  of  our  history  as  a  nation,  silver  fractional 
coins  had  the  prerogatives  of  standard  money,  i.  e.,  were  freely  coined 
and  had  the  status  of  full  legal  tender.     But  in  1853  Congress  deemed 
it  necessary  to  put  this  kind  of  money  into  the  position  of  subsidiary 
coin.     How  do  you  explain  the  fact  that  Congress  got  around  to  this 
opinion  at  about  that   particular  time? 


174  PRINCIPLES  OF  ECONOMICS  [XII 

5.  Between  1890  and  1896  it  was  a  common  practice  to  put  into  notes 
and  mortgages  a  clause  providing  for  payment  in  gold  coin  of  legal 
weight  and  fineness.     Try  to  get  the  proper  explanation  of  this  fact. 

6.  When  I  say  that  12.9  grains  of  gold  .9  fine  is  the  monetary  stand- 
ard of  the  Philippines,  what  is  meant? 

7.  In  the  United  States  in  the  year  1868,  when  gold  payments  on 
treasury  notes  were  suspended  so  that  a  gold  dollar  was  commonly  worth 
from  $1.20  to  $1.40,  one  of  the  great  political  parties  proposed  to  pay 
the  national  debt  in  these  irredeemable  treasury  notes, — which  proposal, 
however,  was  defeated  in  the  Federal  election  of  that  year.     In  discuss- 
ing the  matter,  writers  commonly  speak  as  if  the  national  creditors  ob- 
jected to  being  paid  in  treasury  notes  rather  than  gold;  whereas  no  one 
of  them  probably  would  have  thought  of  asking  for  literal  gold  money. 
Explain  in  scientific  language  what  was  the  precise  issue  of  the  contro- 
versy. 


CHAPTER  XIII 

CREDIT  EXCHANGE 

I 
The  Process  of  Credit  Exchange 

We  showed  m  the  last  chapter  why  exchange  was  not  and  could 
not  to  any  great  extent  be  conducted  on  the  barter  plan,  and  why  a 
mechanism  of  exchange  had  been  built  up,  consisting  of  specialized 
processes  and  instruments  or  media.  We  have  thus  far  discussed 
one  of  the  processes — money  exchange — and  one  set  of  instruments, 
— money.  We  now  pass  to  a  second  process  called  Credit  Exchange, 
and  the  set  of  instruments  employed  by  it,  called  Credit. 

Deficiencies  of  Money. — Money  exchange,  as  we  saw,  is 
superior  to  barter  chiefly  because  of  the  fact  that  it  uses  a  single 
standardized  medium  which  everyone  is  willing  to  accept.  But  it  is 
easily  possible  to  overstate  the  convenience  and  facility  of  trade  re- 
sulting from  the  use  of  this  device.  Everyone  is  willing  to  accept 
money,  we  say ;  but  as  a  matter  of  fact,  if  a  man  sells  a  thousand  or 
ten  thousand  dollars'  worth  of  wheat  or  meat  or  land,  he  usually  is 
very  far  from  willing  to  accept  actual  money  in  exchange.  In  former 
ages,  when  actual  possession  of  the  money  metal  was  prized  as  a 
sign  of  distinction,  possibly  most  individuals  received  without  hesita- 
tion practically  all  the  money  they  could  get.  But  this  is  not  so 
today.  No  man  however  fond  of  wealth  desires  to  have  a  bushel  of 
money  dumped  on  his  floor.  The  heap  would  add  little  to  his  dis- 
tinction, and  would  greatly  embarrass  him. 

But  the  use  of  money  may  be  inconvenient  for  other  reasons 
also.  It  is  unlikely  that  any  would-be  purchaser  will  have  a  bushel 
of  money  to  give.  Because  of  the  difficulty  of  guarding  it,  and  be- 
cause of  its  entire  uselessness  when  not  in  active  circulation,  even 


I76  PRINCIPLES  OF  ECONOMICS  [XIII 

the  richest  men  prefer  to  keep  in  their  possession  at  any  one  time  only 
a  small  quantity  sufficient  to  supply  their  everyday  wants.  When 
one  Requires  a  large  lump  sum,  then,  how  shall  he  obtain  it?  Wait 
till  it  gradually  accumulates,  hoarding  it  as  it  comes  in ;  scurry  here 
and  there,  selling  a  little  something  to  this  man  and  a  little  something 
to  that  till  he  gets  together  a  sum  sufficient  for  his  purchase?  Fur- 
thermore, if  he  buys  -at  a  distance,  at  the  extreme  end  of  the  continent 
or  beyond  an  ocean,  must  the  purchaser  undertake  the  toil  and  ex- 
pense and  danger  of  transporting  the  money  and  delivering  it  into 
the  seller's  hands?  By  no  means.  These  difficulties  are  obviated 
by  the  use  of  a  still  more  highly  developed  medium  of  exchange, 
called  Credit. 

Credit  Exchange  Defined. — Briefly  stated,  credit  exchange 
is  the  exchanging  of  goods  for  goods  through  the  medium,  not  of 
money,  but  of  a  right  to  claim  money.  This  is  implied  in  the  name 
"credit  exchange."  But  this  account  of  the  matter  is  too  compressed 
to  be  adequate.  To  serve  as  a  medium  of  exchange  is  to  be  some- 
thing which  enables  us  to  trade  goods  belonging  to  us  for  other  goods, 
more  easily  and  conveniently  than  we  could  by  direct  barter :  we 
trade  our  goods  for  that  medium,  and  then  trade  that  medium  for  the 
other  goods.  Unless  both  of  these  operations  are  performed,  the 
thing  in  question  is  not  serving  as  a  medium  of  exchange.  It  is  not 
such  a  medium  if  we  merely  get  it  in  exchange  for  our  goods,  and 
stop  there.  If  we  use  the  right  to  money — credit — in  this  way,  we 
have  merely  loaned  to  our  customer  the  money  equivalent  of  the 
goods.  All  in  good  time  he  will  have  to  pay  the  debt  with  money, 
which  money  will  be  the  real  exchange  medium  of  the  transaction. 
In  like  manner,  credit  is  not  a  medium  of  exchange  when  I  merely 
give  it  in  exchange  for  other  people's  goods.  In  that  case,  they  have 
lent  me  the  money  value  of  those  goods.  All  in  good  time  I  shall 
have  to  pay  them  money  which  will,  therefore,  have  been  the  real 
medium  of  exchange  for  the  transaction.  Credit  itself  will  be  the 
real  medium  provided  only  I  use  the  claim  created  by  selling  my 
goods,  to  buy  the  goods  of  the  other  people. 

Reciprocity  of  Credits  Necessary. — It  follows  from  the  last 
paragraph  that,  if  credit  is  to  be  used  as  a  substitute  for  money,  it 


XIII]  CREDIT  EXCHANGE  177 

must  be  capable  of  acting  as  a  true  medium  of  exchange, — after  I 
have  accepted  it  in  exchange  for  my  goods,  it  must  be  able  to  buy  the 
goods  of  other  people.  But,  in  order  that  this  should  be  possible,  it 
is  necessary  that  the  relation  of  debit  and  credit  which  is  inherent 
in  the  system  should  be  reciprocal.  I  must  sell  other  people  goods 
and  other  people  must  sell  me  goods ;  and  the  words  "other  people" 
must  in  some  sense  refer  to  the  same  persons.  If  certain  persons 
wish  to  buy  goods  from  me,  while  I,  in  turn,  wish  to  buy  goods  from 
them,  then  I  can  sell  them  my  goods  for  credit — the  right  to  claim 
money — and  then  use  that  credit  to  buy  their  goods.  In  such  a 
transaction,  credit  will  have  served  as  a  medium  of  exchange.  The 
transaction  uses  a  medium  of  exchange,  since  goods  are  not  directly 
traded  for  goods  but  for  a  go-between ;  and  credit,  rather  than  money, 
is  that  medium,  since  the  reciprocal  claims  cancel,  and  so  money  is 
not  used. 

A  situation  such  as  that  outlined  naturally  arises  between  two 
neighboring  dealers  who  are  mutual  customers.  If  Hoaglin,  the 
clothier,  is  likely  to  sell  Frost,  the  shoe  dealer,  one  hundred  fifty 
dollars  worth  of  clothes  in  the  course  of  the  year  and  to  buy  from 
Frost  one  hundred  thirty  dollars  worth  of  footwear,  credit  can 
easily  serve  as  the  medium,  money  being  used  only  for  the  twenty- 
dollar  balance. 

The  Difficulty. — In  the  illustration  of  credit  exchange  just 
used — book  credit  it  is  commonly  called — reciprocity  of  claims  was 
inevitably  present  because  but  two  persons  were  involved:  if  two- 
sided  trade  went  on  at  all,  it  could  not  help  setting  up  reciprocal 
claims,  which  could  be  used  as  the  medium  of  exchange.  But  situa- 
tions of  this  sort  are  comparatively  rare.  We  do  not  usually  buy 
from,  and  sell  to,  the  same  individual  or  set  of  individuals;  we  are 
far  more  likely  to  buy  from  one  set  and  sell  to  another.  Thus,  the 
farmer  sells  his  corn  and  oats  to  the  elevator  company  and  buys 
nothing  from  that  company  whatever ;  while  he  buys  clothing,  car- 
riages, lumber,  and  other  commodities  from  a  set  of  merchants  to 
whom  he  sells  nothing  whatever.  Here  mutuality  of  claims  is  non- 
existent ;  hence  cancellation  is  out  of  the  question ;  how  then  can 
credit  be  used  as  a  medium  of  exchange? 


I78  PRINCIPLES  OF  ECONOMICS  [XIII 

Solution:  A  Common  Debtor  and  Creditor. — The  solution  is 
not  so  difficult  as  it  appears  at  first  sight.  Even  in  this  situation  a 
true  reciprocity  of  claims  exists, — only  it  exists  between  each  person 
and  all  the  rest  taken  together.  If  the  farmer  could  in  some  way  take 
what  he  owes  everyone  and  set  it  over  against  what  everyone  owes 
him,  a  practically  complete  cancellation  would  be  possible.  He  may 
not  sell  anything  to  any  of  the  particular  persons  from  whom  he  has 
occasion  to  make  purchases ;  but  he  must  sell  to  some  persons,  else  he 
could  not  buy.  It  follows  that,  if  the  proper  apparatus  were  avail- 
able, he  could  use  the  claims  against  other  people  taken  as  a  whole, 
which  his  sales  had  created,  to  buy  the  goods  for  which  he  wished  to 
exchange  his  own.  That  is,  credit  would  here  again  act  as  a  go- 
between,  a  medium  of  exchange.  The  carrying  out  of  such  a 
scheme  plainly  involves  what  we  call  a  pooling  of  the  claims  for  and 
against  the  persons  other  than  the  one  we  are  considering,  growing 
out  of  transactions  with  that  one  person.  No  plan  has  ever  been 
adopted  whereby  such  a  system  could  be  applied  to  all  transactions. 
But  a  device  early  developed  extends  its  use  to  the  major  part  of 
wholesale  transactions  and  in  the  United  States  to  more  than  half 
the  retail  transactions.  That  device  may  be  described  as,  in  general, 
one  which  makes  one  institution  or  group  of  institutions,  a  sort  of 
common  debtor  and  creditor,  and  allows  it  to  effect  settlement  with 
each  of  its  patrons,  as  itself  the  representative  of  all  the  rest. 

Banks  Fill  This  Position. — The  institution  which  commonly 
serves  different  individuals  in  this  capacity  is  the  so-called  commercial 
bank  or  the  commercial  department  in  some  other  type  of  bank.  The 
primary  functions  of  such  an  institution  are,  in  ordinary  banking 
language,  deposit  and  discount — to  care  for  the  current  funds  of  its 
patrons  and  make  short  advances  to  them  as  the  need  may  arise. 
But  an  institution  which  takes  care  of  its  patrons'  current  funds  al- 
most inevitably  is  called  on  to  make  payments  for  them — at  least 
this  is  the  case  in  most  English  speaking  countries ;  and  in  doing  that 
it  naturally  drifts  into  the  position  of  common  debtor  and  creditor. 
When  Mr.  A,  one  of  the  bank's  depositors,  orders  the  bank  by  check 
to  pay  $20  to  another  depositor,  Mr.  B,  and  Mr.  B  deposits  the 
proceeds  of  the  check  in  the  same  bank,  this  act  makes  Mr.  A  the 


XIII]  CREDIT  EXCHANGE  179 

debtor  of  the  bank  for  $20  and  makes  Mr.  B  the  creditor  of  the  bank 
for  the  same  amount.  When,  now,  some  other  depositor  orders  the 
bank  to  pay  $18  for  him  to  Mr.  A,  the  latter  becomes  a  creditor  of 
the  bank  for  this  $18,  which  is  entered  on  his  account,  cancelling  all 
but  $2  of  the  debt  created  by  A's  $20  check  in  favor  of  B.  So, 
when  B  gives  still  another  depositor  of  the  bank  a  check  for,  say, 
$25,  he  thereby  becomes  the  debtor  of  the  bank,  the  pooling  agent, 
for  $25,  which  is  cancelled  by  book  entries  against  his  former  credit 
of  $20,  leaving  a  debit  balance  of  $5.* 

Thus  the  process  goes  on  indefinitely.  Every  check  drawn  by  A 
makes  him  a  debtor  of  the  bank  for  the  amount  named,  and  every 
check  drawn  by  another  depositor  in  A's  favor  makes  him  the 
creditor  of  the  bank  for  that  amount ;  and  the  same  is  true  of  B  or  C, 
or  any  one  of  the  whole  list  of  depositors.  In  short,  we  see  per- 
fectly fulfilled  the  conditions  mentioned  as  necessary  for  the  working 
of  credit  exchange.  Reciprocity  is  established  between  debts  or 
claims;  A's  debts  to  other  people  are  set  over  against  other  people's 
debts  to  him.  And,  given  this  reciprocity,  cancellation  becomes  pos- 
sible, and  so  credit  exchange — exchange  without  the  use  of  money 
— becomes  possible. 

In  the  preceding  illustration  we  have  supposed  that  Mr.  A  and  his 
neighbors  all  keep  deposits  in  the  same  bank.  But  generally  there 
are  several  banks  in  one  community ;  some  are  used  by  a  part  of  the 
population  and  some  by  another  part ;  and  Mr.  A,  whose  transactions 
we  may  suppose  are  many  and  various,  will  have  debits  and  credits 
to  settle  with  the  patrons  of  banks  other  than  his  own.  At  first  sight, 
this  seems  to  result  in  a  return  to  cash  exchange,  since  a  check  on 
one  bank  deposited  with  another  will  not  be  debited  to  the  former 
bank  for  any  length  of  time,  but  will  be  promptly  presented  for 
cash.  In  fact,  however,  the  bank  which  is  debtor  because  of  the 
supposed  transaction  will  doubtless  have  come  into  possession  of 
checks  on  the  creditor  bank  which  it  can  use  to  offset  the  claim 
against  itself.  Even  if  it  has  at  the  time  no  claims  against  that 


1  It  should  be  remembered  that  each  depositor  is  expected  to  keep  some 
balance  with  the  bank,  a  practice  which  insures  that  the  bank  can  safely 
assume  the  position  of  debtor  on  behalf  of  the  man  who  writes  a  check 
in  favor  of  another  depositor. 


T8o  PRINCIPLES  OF  ECONOMICS  [XIII 

particular  bank,  it  will  certainly  have  some  against  other  banks  in 
the  community ;  and,  since  all  the  banks  will  settle  their  mutual  obli- 
gations on  a  pooling  plan,  these  claims  against  other  banks  will  do 
just  as  well  in  offsetting  its  debits  as  claims  against  its  actual 
creditor. 

The  Bank  Clearing. — We  thus  come  to  another  very  im- 
portant development  of  credit-exchange,  the  clearing,  or  settlement 
of  mutual  obligations  among  a  number  of  different  banks.  Here 
the  same  device  which  enables  Mr.  A  to  adjust  his  debits  and  credits 
with  a  minimum  use  of  actual  money,  is  applied  to  settle  the  mutual 
obligations  of  banks.  In  general,  the  plan  is  to  set  up  a  common 
agent,  a  clearing-house  association,  which  becomes  the  creditor  of 
each  bank  for  claims  of  all  other  banks  against  it,  and  becomes  its 
debtor  for  claims  against  all  other  banks.  At  regular  intervals  a 
balance  is  struck  and  the  one  which  proves  to  be  debtor,  the  bank 
or  the  clearing-house,  pays  the  balance.  Naturally,  the  clearing- 
house settles  first  with  the  banks  which  prove  to  be  debtors,  and 
then  uses  the  money  thus  obtained  to  pay  the  creditor  banks. 

Inter-Local  Exchange. — Our  discussion  has  thus  far  had  to 
do  with  exchange  carried  on  through  banks  between  persons  in  the 
same  community.  Another  and  much  older  form  is  inter-local 
credit-exchange,  or  what  we  call  Exchange  in  the  pre-eminent  sense. 
This  form  is  resorted  to  for  making  payment  between  different  cities 
and  countries  with  a  minimum  use  of  money.  Here  we  have  again 
the  same  familiar  device :  claims  for  and  against  different  countries, 
debits  and  credits,  get  into  common  hands  so  that  reciprocity  is  es- 
tablished and  cancellation  is  made  possible.  Certain  institutions  in 
each  country,  banks  or  exchange  houses,  buy  up  all  the  claims  on  the 
other  countries  and  also  sell  for  the  use  of  their  patrons  claims  on 
those  other  countries.  Thus,  they  become  the  common  creditors 
and  the  common  debtors  of  the  dealers  of  their  country  in  its  rela- 
tions to  others ;  and  the  debit  and  credit  relations  which  they  main- 
tain with  other  countries  are  maintained  with  institutions  similar  to 
themselves.  It  therefore  becomes  easy  to  set  the  debits  of  a  country 
over  against  its  credits,  cancel  these  in  so  far  as  they  are  equal,  and 


XIII]  CREDIT  EXCHANGE  181 

effect  a  complete  settlement  by  paying  or  receiving  a  small  balance 
in  money. 

II 

Instruments  of  Credit  Exchange 

As  coins  and  bills  of  various  different  kinds  constitute  the  in- 
struments or  media  used  in  money  exchange,  so  a  variety  of  paper 
documents  constitute  those  used  in  credit  exchange.  Some  of  these 
take  the  form  of  a  direct  promise  between  man  and  man  to  deliver 
a  specified  amount  of  money  at  a  specified  time.  But,  inasmuch  as 
the  promise  must  ordinarily  be  made  good  through  the  agency  of  a 
third  party  or  institution,  most  of  these  documents  are  really  orders 
made  by  one  person,  called  the  drawer,  in  favor  of  another  person, 
called  the  payee,  upon  a  third  person  or  institution,  called  the  drawee. 
If  the  payee  does  not  himself  find  it  convenient  to  present  the  docu- 
ment to  the  drawee  for  cash  or  for  cancellation  against  his  own 
promises  to  the  drawer,  he  can  transfer  it  to  another  person  by  in- 
dorsement— writing  his  own  name  across  the  back,  with  or  without 
some  specific  directions  as  to  payment. 

The  most  familiar  credit  instrument  is  the  bank  check  which  has 
already  been  mentioned.  It  is  an  order  for  the  payment  of  money 
drawn  by  a  man  upon  the  bank  where  his  own  money  is  kept  in 
deposit.  It  is  used  principally  within  a  single  town  or  limited  com- 
munity where  the  drawee  bank  is  located,  and  where  both  drawer 
and  payee  are  known.  Inter-local  exchange  makes  very  considerable 
use  of  the  check,  though  banks  much  prefer  other  instruments  spe- 
cially adapted  to  this  purpose.  Most  important  of  these  is  the 
bank  draft,  an  order  for  the  payment  of  money  drawn  by  one  bank 
on  a  bank  in  another  place,  in  favor  of  another  party.  A  bank  draft 
is  employed  when  the  initiative  in  settling  a  debt  is  taken  by  the 
debtor.  He  buys  the  draft,  and  mails  it  to  his  creditor ;  the  creditor 
then  gets  cash  or  credit  for  it  from  his  bank ;  and  the  bank,  if  not 
itself  the  drawee  named  in  the  draft,  proceeds  to  collect  from  the 
bank  which  is.  Another  class  of  exchange  instruments  similar  to 
the  bank  draft  are  so-called  money  orders, — postal  or  express  orders. 
These  are  drawn  by  local  agents  of  the  institution  issuing  them  upon 
the  central  office,  are  sold  to  the  debtor,  and  sent  by  him  to  the 


182  PRINCIPLES  OF  ECONOMICS  [XIII 

creditor,  who  collects  from  the  agent  of  the  issuing  institution  located 
in  his  own  town.  When  the  initiative  in  settling  a  transaction  is 
taken  by  the  seller  or  creditor,  the  instrument  employed  is  named  a  bill 
of  exchange,  though  this  phrase  is  also  often  applied  to  international 
bank  drafts.  Such  a  bill  of  exchange,  also  called  a  commercial  draft, 
is  an  order  for  the  payment  of  money  drawn  by  a  seller  or  creditor 
upon  his  debtor  in  favor  of  the  drawer  or  his  banker,  (If  in  favor 
of  himself,  he  indorses  it  over  to  his  banker.)  The  creditor  turns  the 
draft  over  to  his  banker  and  gets  credit  for  the  amount  named,  where- 
upon the  banker  sets  out  to  collect  from  the  drawee  through  bank- 
ing correspondents. 

Ill 

The  Rate  of  Exchange 

Definition. — A  matter  of  much  importance  in  connection  with 
credit  exchange  is  the  rate  of  exchange,  particularly  the  rate  in  for- 
eign exchange.  As  we  have  just  learned,  money  payments  between 
the  people  of  different  communities  are  effected  through  agents  who 
assume  the  position  of  common  creditor  and  common  debtor  for 
each  community.  An  agent  in  one  community  buys  up  money  claims 
on  other  communities  from  persons  having  such  claims  to  dispose  of ; 
and  he  sells  money  claims  on  other  communities  to  persons  needing 
them  to  make  payments  in  those  other  communities.  Thus,  there  is 
developed  a  traffic  in  such  claims,  a  traffic  in  "exchange,"  as  it  is 
called ;  and  the  price  at  which  exchange  sells — at  least  exchange  be- 
tween different  countries — is  called  the  rate  of  exchange.  Stated 
more  formally :  the  rate  of  exchange  is  the  price  in  one  country  paid 
in  the  money  of  that  country  for  the  right  to  dispose  of  a  unit  of  the 
money  of  some  other  country  in  that  other  country,  or  at  least  in 
some  country  other  than  the  one  in  which  the  purchase  is  made. 
Thus,  if  I  wish  to  buy  from  my  bank  the  right  to  have  five  pounds 
sterling  paid  on  my  behalf  in  London,  and  find  myself  obliged  to  pay 
for  that  right  $4.87  per  pound,  I  say  that  the  rate  of  exchange  on 
London  is  $4.87. 

In  domestic  exchange, — exchange  between  different  parts  of  the 
same  country, — the  rate  of  exchange  usually  means  the  difference 
between  the  face  value  of  an  instrument  of  exchange  and  what  is 


XIII]  CREDIT  EXCHANGE  183 

paid  for  it.  Thus,  if  I  say  that  the  Chicago  rate  of  exchange  on 
New  York  is  15  cents  premium  per  thousand,  I  mean  that,  in  selling 
a  claim  for  $1,000  on  New  York,  a  Chicago  dealer  would  get  his 
$1,000  and  fifteen  cents  additional. 

The  Par  of  Exchange. — In  working  out  the  price  or  rate  of 
exchange,  the  market  starts  with  the  natural  value  of  the  unit  of 
the  money  wanted,  as  measured  in  the  money  with  which  it  is  bought 
— that  is,  the  value  as  it  would  be  if  there  were  no  difference  of 
place,  if  the  buyer  of  English  money  bought  it  right  in  New  York  to 
be  delivered  in  New  York.  If  the  two  countries  have  the  same 
standard,  then  the  natural  value  of  either  money  in  terms  of  the 
other  can  be  ascertained  by  a  simple  operation  in  division.  Thus, 
one  dollar  contains  23.22  grains  of  fine  gold ;  and  the  English  pound, 
113  grains.  The  pound,  therefore,  is  naturally  worth  in  our  money 
as  many  dollars  as  23.22  is  contained  in  113,  or  $4.866.  This  natural 
price  of  a  foreign  money  unit,  measured  in  terms  of  the  home  money, 
is  technically  known  as  the  par  of  exchange. 

Variations  in  the  Rate  of  Exchange. — The  rate  of  exchange 
varies  above  or  below  the  par  of  exchange  according  as  the  demand 
for  exchange  at  par  is  in  excess  of  the  supply  or  vice  versa.  If  the 
United  States  is  selling  great  quantities  of  cotton  and  wheat  to  the 
people  of  Europe  and  buying  comparatively  little  from  them,  then 
claims  on  Europe  will  be  abundant  and,  other  things  being  equal, 
cheap;  those  Americans  who  have  claims  on  Europe  to  sell  will  be 
obliged  to  sell  them  cheap,  while  those  who  need  such  claims  can  buy 
them  cheap.  On  the  other  hand,  if  the  United  States  is  buying  many 
goods  from  the  people  of  Europe  and  selling  them  comparatively 
few,  then  claims  on  Europe  will  be  scarce  and,  other  things  being 
equal,  dear;  those  Americans  having  claims  on  Europe  to  sell  can 
obtain  high  prices,  while  those  needing  to  buy  such  claims  will  be 
obliged  to  pay  high  prices. 

Limits:  Gold  Points. — These  variations  of  the  rate  of  ex- 
change above  and  below  par  are  limited  by  the  cost  to  exchange  houses 
of  transporting  the  money  itself  from  the  one  place  to  the  other, — 


184  PRINCIPLES  OF  ECONOMICS  [XIII 

it  being  understood  that  cost  includes  a  reasonable  profit  to  the  ex- 
change dealer.  Any  wider  variations  would  give  exceptional  profit 
to  the  exchange  dealers,  which  would  stimulate  their  competition, 
and  so  reduce  the  difference  to  this  amount.  In  London  exchange, 
the  possible  variation  from  par  is  commonly  in  the  neighborhood 
of  three  cents;  in  other  words,  the  rate  ranges  from  about  $4.835  to 
$4.895.  These  are  called  the  gold  points  because,  outside  these 
points,  sending  gold  would  be  cheaper  than  using  exchange. 

ILLUSTRATIVE  PROBLEMS 

* 

1.  Suppose  that  you  send  a  check  on  the  National  Bank  of  Ann 
Arbor  to  the  Newcomb-Endicott  Company  of  Detroit  to  pay  for  some 
goods  purchased;  and  suppose  that  when  the  check   finally  gets  back 
to  you  it  shows  the  following  indorsements :     ( i )  Pay  to  the  Peninsular 
Savings  Bank  of  Detroit,  the  Newcomb-Endicott  Company.     (2)   Pay 
to  the  State  Savings  Bank  of  Ann  Arbor,  Peninsular  Savings  Bank  of 
Detroit.     (3)     Paid  through  the  Clearing  House,  State  Savings  Bank 
of  Ann  Arbor.    Trace  the  course  of  this  check  from  the  indorsements. 

2.  Henry  T.  Crouch  of  Erie  buys  $1,275  worth  of  wheat  from  T.  C. 
Craig  of  Detroit. 

(a)  Suppose  settlement  to  be  effected  with  a  wheat  bill  of  exchange 
(also  called  a  sight  draft)  and  write  out  the  substance  of  the  bill  which 
would  be  used. 

(b)  Suppose  settlement  to  be  made  with  a  check  and  write  out  a 
facsimile  (in  substance). 

(c)  Suppose  settlement  to  be  made  with  bank  draft  and  write  out  a 
facsimile  (in  substance). 

3.  Whichever  method  of  settling  the  transaction  involved  in  the  last 
problem  is  used,  the  particular  credit  document  employed  will  inevitably 
take  quite  a  journey  from  bank  to  bank  while  it  is  being  collected. 

(a)  Describe  an  imaginary  course,  which  it  would  very  likely  take 
if  it  were  a  sight  bill  of  exchange. 

(b)  Same,  if  it  were  a  check. 

(c)  Same,  if  it  were  a  bank  draft.     (Compare  Problem  i.) 

4.  We  buy  a  good  deal  from  Brazil,  but  sell  her  little.    We  sell  a 
great  deal  to  Great  Britain,  but  buy  from  her  much  less.     Can  you  im- 
agine a  way  in  which  one  of  these  trades  furnishes  a  medium  of  ex- 
change for  the  other? 


XIII]  CREDIT  EXCHANGE  185 

5.     Oct.  i,  1907,  the  different  banks  of  Ann  Arbor  brought  to  the 
clearing  claims  against  each  of  the  other  banks  as  follows: 

No.  i  against  No.  2  against  No.  3  against 


No.  2  $2213.19 
No.  3  1865.09 
No.  4  2415.96 
No.  5   512.21 

No.  i  $4284.78 
No.  3  2172.45 
No.  4  3043.18 
No.  5   655.87 

No.  i  $4974.66 
No.  2  1607.79 
No.  4  1093.24 
No.  5   625.88 

Total  $7006.45        Total  $10156.28        Total  $8301.57 
No.  4  against          No.  5  against 


No.  i  $3078.73 
No.  2     1793.16 
No.  3      97373 
No.  5    4633.96 

No.  i  $  332.15 
No.  2      377-17 
No.  3     151546 
No.  4      181.56 

Total  $10479.58  Total  $2406.34 

Compute  the  balance  for  or  against  each  bank. 

6.  Supposing  all  the  claims  of  the  Ann  Arbor  banks  on  one  another 
which   appear   in  the  last  problem  to  have  consisted   of   checks   which 
were  used  in  the  usual  course  of  business  transactions. 

(a)  What  must  have  been  the  total  volume,  expressed  in  money,  of 
the  transactions  thus  effected? 

(b)  How  much  actual  cash  was  needed  to  effect  these  transactions? 

(c)  What  per  cent  of  the  total  volume  of  transactions  did  this  cash 
amount  to? 

(d)  What  is  the  significance  of  these  facts? 

7.  Not  many  years  ago  it  was  estimated  that  the  per  capita  money 
circulation  of  England  was  about  $11  while  that  of  France  was  about  $51 ; 


yet,  as  every  one-  knows,  there  was  at  least  as  much  business  per  capita 
carried  on  in  England  as  in  France.  How  could  the  difference  in  the 
amounts  of  circulating  medium  required  be  explained  ? 

8.  Some  writers  represent  the  development  of  credit-exchange  as  a 
return  to  barter.     Show  that  this  is  not  true — that  credit-exchange  is 
still  mediated  exchange,  nay  more,  that  it  is  money  exchange. 

9.  Suppose  I  wish  to  buy  a  bank  draft  for  £200  on  London.     With 
London  exchange  at  $4.855,  what  should  I  be  able  to  get  the  draft  for? 

10.  A  wheat  exporter  of  New  York  draws  a  bill  on  his  London 
customer  for  £1375.     What  should  he  be  able  to  get  for  this  bill  with 
London  exchange  selling  at  $4.87?  with  London  exchange  at  $4.84? 


!86  PRINCIPLES  OF  ECONOMICS  [XIII 

11.  Suppose  that  a  New  York  importer  can  get  50  gross  of  Sheffield 
razors  delivered  in  New  York  for  44  pence  each  (the  duty  included),  and 
that  he  can  sell  them  for  95  cents  each.     What  would  be  his  profit  on 
such  a  transaction  if  the  rate  of  exchange  on  London  were  $4.84?  if  the 
rate  were  $4.87? 

12.  From  the  last  two  problems  what  principles  can  you  deduce  as 
to  the  effect  which  a  high  or  low  rate  of  exchange  tends  to  have  on 
exports?     On  imports? 

13.  "The  greater  part  of  our  circulating  medium  consists,  not  of 
money,  but  of  deposit  currency."     Explain  what  is  meant  by  deposit 
currency. 

14.  Near  what  point  would  you  expect  the   rate  of  exchange  on 
Europe  to  be  found  in  the  fall  of  the  year  ?     Why  ? 

15.  "A  matter  very  frequently  overlooked  by  the  public  is  that  a 
large  share  of  the  bank  deposits  of  a  country  like  the  United  States 
grow  out  of  loans  and  so  do  not  add  to  the  cash  holdings  of  the  banks." 
Explain  how  this  is  so. 


CHAPTER  XIV 

SOME  MONEY  TRUISMS 

Having  briefly  analyzed  and  described  the  system  of  Money  and 
Credit  Exchange,  it  is  now  in  order  to  set  forth  some  of  the  prin- 
ciples governing  that  system.  It  is  much  too  early  in  our  study  to 
attempt  anything  resembling  a  thorough  exposition  of  the  theory  of 
money.  Nevertheless  a  few  of  the  simpler  principles  which,  though 
little  more  than  truisms,  are  frequently  overlooked  by  the  public 
with  the  result  that  foolish  errors  gain  acceptance  and  lead  to  hurtful 
legislation,  should  receive  attention  at  the  very  outset. 

Money  Small  Part  of  Total  Wealth. — The  first  point  requiring 
emphasis  has  to  do  with  the  common  fallacy  which  regards,  or  seems 
to  regard,  money  as  the  only  kind  of  wealth.  In  earlier  centuries, 
whole  communities  have  entertained  such  an  idea,  and  even  in  our 
own  day  many  people  stand  dangerously  close  to  the  same  position. 
Anything  that  reduces  the  monetary  stock  of  a  community  tends,  in 
their  opinion,  to  make  that  country  poorer,  no  matter  what  the 
reducing  force  may  be ;  and  anything  that  increases  the  monetary 
stock,  whether  a  balance  of  trade  causing  the  import  of  money  from 
other  countries,  or  coinage  by  the  government  within  the  country, 
must  have  the  effect  of  increasing  wealth. 

There  is  no  doubt  some  little  excuse  for  this  attitude  of  mind  in 
the  predominant  place  which  money  holds  in  our  everyday  thought 
and  speech  concerning  wealth.  We  express  wealth,  of  whatever 
kind,  in  terms  of  money,  for  example,  when  we  say  that  "Smith  has 
inherited  a  half  million  of  dollars,"  though  as  a  matter  of  fact  he 
has  inherited  only  land,  factories,  and  stocks  valued  at  a  half  million 
dollars.  It  is  a  fact,  too,  that  money  will  procure  for  us  any  other 
kind  of  wealth  we  may  desire,  and  hence  itself  appears  to  us  the 
most  efficient  and  desirable  form  of  wealth,  the  wealth  par  excellence. 

187 


!88  PRINCIPLES  OF  ECONOMICS  [XIV 

Nevertheless  these  considerations  surely  do  not  justify  us  in  con- 
ceiving money  to  be  the  only  form  of  wealth.  Any  kind  of  goods 
capable  of  yielding  satisfactions  and  having  exchange  value — dia- 
monds, bullion,  land,  or  what  not — are  wealth  just  as  truly  as  coined 
money.  It  is  essential  therefore  to  keep  always  in  mind  the  follow- 
ing proposition : 

Money  is  simply  one  particular  kind  among  many  kinds  of 
wealth. 

Money  Small  Part  of  Total  Capital. — The  second  fact  need- 
ing to  be  insisted  on  at  this  point  is  that  money  is  not  the  only  kind 
of  capital.  Considered  as  an  instrument  which  we  employ  to  facili- 
tate the  exchange  of  goods  and  to  accumulate  or  transfer  stores  of 
value,  money  is  of  course  capital,  just  as  truly  as  buildings,  engines, 
or  machinery.  But  certain  peculiarities  of  money  have  led  careless 
persons  into  thinking  and  talking  about  it  as  if  it  were  the  only  true 
capital.  Thus  all  forms  of  capital,  like  all  forms  of  wealth  in  gen- 
eral, are  computed  and  expressed  in  terms  of  money,  as  when  we 
say,  "Mr.  Craig  has  $200,000  of  capital  in  the  milling  business." 
We  seem  to  mean  here  that  $200,000  in  money  constitutes  the  capital 
which  Mr.  Craig  devotes  to  the  production  of  flour ;  but  what  we 
should  mean  is  that  Craig  owns  and  devotes  to  such  production  cer- 
tain buildings,  dams,  races,  and  machinery  which  have  a  value 
measured  in  money  of  $200,000.  He  may  not,  and  almost  certainly 
does  not,  possess  anything  like  that  amount  of  money  capital,  as 
money. 

Again,  people  are  sometimes  led  to  look  upon  money  as  the  only 
form  of  capital,  from  the  fact  that  money  constitutes  the  immediate 
form  in  which  most  capital  is  accumulated.  A  person  desiring  to 
accumulate  a  fund  of  capital,  to  invest  in  the  milling  business,  let  us 
say,  puts  away  his  savings  in  the  form  of  money  or  credit  with  his 
bank ;  and  only  after  the  sum  of  money  or  credit  has  grown  large 
does  he  part  with  it,  obtaining  in  exchange  the  capital  goods — lumber, 
engines,  and  machines — necessary  to  commence  production.  Still, 
the  money  stage  of  capital  is  obviously  only  temporary  and  transi- 
tional ;  it  lasts  only  while  enough  is  being  stored  up  to  bring  in  return 
an  appreciable  amount  of  capital  in  another  sense.  For  this  money 


XIV]  SOME  MONEY  TRUISMS  189 

is  only  the  representative  form  of  capital,  the  shadow,  not  the  sub- 
stance. At  the  same  time  that  the  capitalist  is  accumulating  stores 
of  money  or  bank  credit,  other  men  are  manufacturing,  practically, 
if  not  literally,  to  his  order,  lumber,  engines,  and  machines;  and 
these  other  things  for  which  the  capitalist,  or  someone  who  borrows 
from  him,  exchanges  his  store  of  money  or  bank  credit,  constitute 
the  real,  final,  form  of  capital.  The  truth  embodied  in  the  following 
proposition  should,  therefore,  be  constantly  borne  in  mind. 

Money  is  simply  one  among  many  kinds  of  capital  (capital 
goods),  i.  e.,  products  which  are  wanted,  not  for  their  own  sakes, 
but  for  the  sake  of  other  things  which  we  can  get  through  them; 
and  relatively,  money  forms  a  rather  small  portion  of  the  total  cap- 
ital of  the  community. 

Only  Enough  Money  Wanted. — Another  mistaken  notion 
with  respect  to  money,  which  has  caused  a  great  deal  of  trouble  in  the 
past  and  is  still  very  widely  held,  conceives  that  a  country  can  never 
have  enough  money, — can  to  advantage  increase  its  stock  of  this 
particular  form  of  capital  indefinitely.  Every  addition  is  eagerly 
welcomed ;  every  withdrawal  is  looked  on  with  anxiety.  Increasing 
the  quantity  of  money  is  offered  as  a  panacea  for  almost  every  un- 
desirable feature  of  business.  All  this  is,  of  course,  very  hard  for 
the  student  to  comment  on  with  patience.  The  quantity  of  money 
a  country  can  advantageously  supply  itself  with  is  wholly  a  matter 
of  the  need,  the  money  work  to  be  done,  over  against  the  quantity 
of  its  resources  which  it  can  afford  to  use  to  satisfy  this  particular 
need  in  view  of  the  relation  between  its  total  needs  and  its  total 
resources.  Doubtless  there  is  no  way  of  ascertaining  with  precision 
just  how  much  this  means.  But  that  it  is  a  limited  amount  no  one 
would  deny.  The  actual  work  in  which  the  money  stock  of  a 
country  is  at  any  moment  being  employed  is  serving  as  reserves  be- 
hind the  credit  of  the  country,  passing  from  hand  to  hand  in  ex- 
change for  goods  and  in  payment  of  obHgations,  and  being  held  by 
people  in  reserve  for  current  uses  and  in  the  process  of  accumulating 
capital.  For  the  uses  which  involve  passing  from  hand  to  hand, 
any  particular  pieces  of  money  will  be  used  over  and  over  again, 
so  that  the  total  needed  for  this  purpose  will  be  much  smaller  than  the 


xgo  PRINCIPLES  OF  ECONOMICS  .  [XIV 

total  amount  of  work  to  be  done  would  seem  to  indicate.  Further,  a 
large  share  of  the  money  work  of  this  kind  needing  to  be  done  is 
performed  by  credit  substitutes  which  are  extemporized  for  each 
transaction ;  and  their  volume  has  little  reference  to  the  quantity  of 
money  proper  in  the  country.  It  is  thus  possible  that  the  country 
should  experience  great  changes  in  the  money  work  to  be  done  with- 
out any  inconvenience  resulting,  even  though  the  quantity  of  money 
had  not  shown  a  corresponding  change. 

But  not  only  is  the  community's  need  for  money  a  quite  limited 
quantity,  it  is  surely  very  foolish  to  want  to  have  more  than  this.  To 
insist  on  supplying  ourselves  with  a  larger  amount  is  like  filling  up 
one's  house  with  cook  stoves  or  tubs  or  washing  machines.  Any  time 
or  energy  which  we  expend  in  acquiring  such  objects  beyond  the 
needs  of  the  kitchen  and  laundry  lays  upon  us  a  burden  in  caring  for 
them,  and,  worse,  it  reduces  the  time  and  energy  which  we  have  to 
use  in  supplying  ourselves  with  fuel,  food,  clothing,  and  other 
needed  articles.  Putting  this  point  into  a  formal  proposition  gives 
us  a  third  principle. 

Money  is  simply  one  particular  kind  of  useful  instrument  of 
which  our  stock  should  be  large  enough  to  do  the  money  work  need- 
ing to  be  done  as  well  as  we  can  afford  to  have  it  done,  but  of  which 
we  do  not  want  an  excess  any  more  than  we  want  an  excess  of 
chairs,  clothes,  stoves,  engines,  or  any  other  useful  article. 

Money  Naturally  in  Circulation. — A  fourth  widely  accepted 
fallacy  connects  itself  with  the  supposed  advantages  of  "putting 
money  into  circulation."  ^  Exactly  what  this  phrase  means  in  popular 
usage  is  often  hard  to  determine.  If  it  means  causing  money  to 
flow,  or  pass  from  hand  to  hand,  the  phrase  is  merely  an  empty  one 
without  excuse  for  being.  Money  is  always  in  circulation,  passing 
from  one  person  to  another  in  purchase  of  goods,  or  held  awaiting 
occasion  for  such  use.  It  will  circulate  anyway ;  from  its  very  nature 
it  is  bound  to  circulate.  Or  perhaps  the  phrase  means  to  render 
money  more  active,  cause  it  to  spend  a  greater  part  of  the  time  actually 
going  through  the  air,  effecting  exchanges,  instead  of  lying  motionless 
in  men's  pockets.  But  to  expect  that  any  benefit  will  result  from 
causing  money  to  change  hands  a  greater  number  of  times  in  an 


XIV]  SOME  MONEY  TRUISMS  191 

hour  or  in  a  day  is  of  course  absurd.  There  is  nothing  beneficial 
in  the  exchange,  per  sc,  of  money,  because  there  is  nothing  beneficial 
in  the  exchange,  per  se,  of  goods.  The  exchange  of  goods  should 
occur  just  often  enough  to  enable  us  to  dispose  of  those  we  have 
produced  and  to  get  possession  of  other  goods  which  will  be  of  most 
advantage  to  us  as  consumers.  Any  more  exchanging  would  be, 
obviously,  a  waste  of  our  time  and  effort.  But,  since  money  passes 
from  person  to  person  merely  as  a  counter,  a  check  against  other 
goods,  the  number  of  times  it  can  advantageously  change  hands  is 
limited  to  the  number  of  times  those  other  goods  can  advantageously 
change  hands.  To  pass  it  more  frequently — if  that  were  possible — 
would  be  merely  a  purposeless  waste. 

There  is  one  other  possible  interpretation  for  the  phrase.  By 
"putting  money  into  circulation"  some  people  mean  creating  a  de- 
mand, which  would  not  otherwise  exist,  for  goods  and  services,  thus 
increasing  the  sales  and  the  incomes  of  people  generally  and  making 
the  whole  community  more  prosperous.  This  belief  is  no  more 
tenable  than  the  ones  j'ust  discussed ;  but  since  the  particular  fallacy 
involved  is  one  in  contravention  of  a  principle  of  trade  which  we 
designate  Say's  Law,  and  which  is  treated  in  the  next  chapter,  we 
must  reserve  the  consideration  of  this  fallacy  for  that  connection. 
The  chief  point  of  our  present  discussion  may  be  summarized  as 
follows : 

Broadly  speaking,  it  is  of  the  very  nature  of  money  to  circulate 
(in  person  or  by  proxy),  that  is,  to  pass  from  one  person  to  another 
in  purchase  of  goods  or  to  be  held  awaiting  the  occasion  for  such  use. 

Money  Naturally  Remains  Money. — Another  truism  which 
needs  only  to  be  understood  to  command  immediate  acceptance,  and 
yet  is  constantly  overlooked,  has  to  do  with  the  fact  that  the  stock 
of  money  is  not  necessarily  any  measure  of  the  existing  wealth  of 
a  community.  When  we  complain  of  the  squandering  of  a  great 
capital  by  a  worthless  heir,  people  at  once  say,  "I  don't  see  that 
any  harm  is  done.  The  money  spent  by  the  foolish  heir  is  still  here. 
It  has  only  been  transferred  to  better  hands." 

Of  course  the  money  is  still  here.  Money  is  a  bit  of  social  ma- 
chinery of  a  highly  durable  character,  which  lasts  almost  indefinitely, 


1 92 


PRINCIPLES  OF  ECONOMICS  [XIV 


needing  only  small  additions  to  keep  it  intact,  like  such  permanent 
forms  of  capital  as  roads,  canals,  etc.  Of  course,  then,  the  money  is 
still  in  existence  just  as  if  the  spendthrift  had  not  thrown  it  about 
him  so  freely  for  yachts,  dances,  feasts,  and  other  frivolities.  But, 
on  the  other  hand,  there  is  a  total  lack  of  something  else  which  would 
have  come  into  being  if  the  son  had  followed  in  the  footsteps  of  his 
father.  The  father  would  have  looked  upon  his  money  as  a  tempor- 
ary or  transitional  form  of  capital,  and  would  have  gone  on  to 
consummate  the  process  of  capital  production  by  the  purchase  of 
productive  goods — engines,  cars,  bridges,  shops.  These  goods  could 
have  been  produced  by  the  same  labor  which  was  expended  in  min- 
istering to  the  young  man's  follies,  and  they  would  have  continued 
for  years  to  give  off  services,  instead  of  totally  disappearing,  like 
the  orchestra  music  or  the  champagne,  over  night.  As  a  result  of 
the  young  man's  spending,  therefore,  society  as  a.  whole  is  vastly 
poorer  than  it  might  have  been,  even  though  the  quantity  of  money 
is  not  altered  in  the  least. 

Broadly  speaking,  it  is  of  the  very  nature  of  money  to  remain 
money — not  to  be  consumed  in  the  sense  of  being  finally  absorbed 
into  the  life  of  any  individual.  Hence  the  fact  that  the  stock  of 
money  is  unchanged  proves  nothing  as  to  how  the  amount  of  wealth 
or  capital  is  affected  by  particular  lines  of  conduct. 

Trade  Does  Not  Drain  Off  Money. — A  final  fact  deserving- 
mention  in  this  place  relates  to  the  effect  of  foreign  trade  upon  the 
stock  of  money  in  any  community.  "Everything  we  buy  abroad," 
so  runs  a  popular  fallacy,  "takes  just  so  much  money  out  of  the 
country,"  and  the  conclusion  is  drawn  that  the  country  thereby  falls 
into  great  economic  distress.  Now  a  moment's  reference  to  the 
facts  set  forth  in  our  analysis  of  the  Credit  Exchange  should  make 
clear  to  anyone  the  error  in  this  belief.  We  do  not  make  our  pur- 
chases abroad  with  money,  but  with  instruments  of  credit.  In  like 
manner,  we  sell  our  goods  abroad,  not  for  money,  but  for  instru- 
ments of  credit.  These  two  sets  of  instruments  are  cancelled  against 
each  other,  only  balances  going  in  money;  so  that  the  amounts  of 
money  actually  passing  from  one  country  to  another  are  very  insig- 
nificant. Further,  of  course,  those  balances  will  naturally  be  in  favor 


XIV]  SOME  MONEY  TRUISMS  193 

of  any  particular  country  just  as  much  as  against  it.  That  is,  there 
will  very  likely  be  no  net  movement  of  money  at  all. 

There  is  indeed  one  condition  under  which  there  will  tend  to  be 
a  net  outward  movement  of  money  from  a  country  practically  all  the 
time.  If  we  are  a  gold  producing  country  and  spend  much  of  our 
strength  producing  this  metal,  and  little  in  producing  other  goods 
which  we  can  export  to  pay  for  our  imports,  then,  of  course,  the 
balance  of  credit  against  us  will  be  great,  and  we  will  have  to  export 
much  money  to  cancel  it.  But  even  here  we  are  not  exporting  money 
in  any  true  sense.  If  we  spend  much  time  producing  gold,  we  prob- 
,ably  mine,  refine,  and  subsequently  coin  into  money  a  far  greater 
amount  than  we  can  advantageously  use  as  money.  So  far  as  our 
internal  business  is  concerned,  therefore,  this  excess  is  hardly  to  be 
called  money ;  it  is  merely  the  metal,  gold,  a  product  of  our  labor, 
like  wheat,  or  shoes,  or  pork,  which  we  can  and  should  ship  abroad 
to  those  who  desire  it,  in  payment  for  the  products  which  we  desire 
of  them. 

But,  while  a  country  which  is  a  large  producer  of  gold,  the  money 
metal,  may  show  a  large  net  export  of  this  kind  of  money,  this  will 
not  be  the  case  with  other  countries.  Those  which  produce  none  at 
all  will  in  the  long  run  show  a  net  import  of  such  money ;  while  those 
which  produce  just  about  enough  to  meet  their  own  needs  will  have 
neither  a  net  export  nor  a  net  import.  Between  countries,  as  within 
countries,  money  will  act  just  as  a  medium  of  exchange  must  act. 
That  is,  it  will  come  and  go,  go  and  come, — being  wanted  not  to  use 
for  eating  or  wearing  or  warming  houses  or  for  any  purpose  that 
involves  retaining  possession  of  it  or  destroying  it,  but  to  use  in 
exchanging  our  products  for  the  products  of  other  countries. 

It  is  of  the  very  nature  of  money  to  go  back  and  forth  between 
communities;  trade  with  the  outside  world  does  not  of  itself  tend  to 
take  away  our  money. 

ILLUSTRATIVE  PROBLEMS 

i.  "Foreign  trade  can  add  to  the  national  wealth  only  when  it  brings 
in  a  money  balance." 

(a)  What  is  the  principal  thing  to  be  gained  by  maintaining  trade 
relations  with  the  outside  world? 


I94  PRINCIPLES  OF  ECONOMICS  [XIV 

(b)     When  would  it  be  of  advantage  to  have  our  foreign  trade  bring 
in  a  money  balance? 

2.  "A  nation  is  so  much  poorer  by  every  dollar  it  sends  out,  just  as 
an  individual  is  so  much  poorer  by  every  dollar  he  spends."     Criticize 
both  clauses. 

3.  "Everything  we  buy  abroad  takes  just  so  much  money  out  of 
the  country." 

Show  that  this  cannot  be  true  whether  it  is  meant  that  such  buying 
abroad  takes  the  money  out  immediately  or  only  ultimately. 

4.  Suppose  that  official  reports  from  all  the  banks  of  a  certain  city 
show  that,  on  an  average,  93  per  cent  of  the  deposits  received  during  a 
certain  day  consisted  of  checks,  only  7  per  cent  being  in  the  form  of 
money.     What  important  fact  with  respect  to  the  conduct  of  business  in 
that  city  would  be  thereby  disclosed? 

5.  "It  is  sometimes  asked  whether  the  raising  of  a  government  loan 
to  cover  ordinary  expenditures  really  causes  capital  to  be  lost,  since  the 
coins  received  by  the  government  remain  in  existence, — even  remain  in 
the  country.     This  objection  has  no  weight  whatever" — Pierson's  Prin- 
ciples of  Economics. 

Show  that  the  statement  in  italics  is  correct. 

6.  "We  pay  no  million  dollars  per  annum  for  the  carrying  of  prod- 
ucts between  this  and  foreign  countries.     Think  of  it.     One  hundred  and 
ten  million  dollars  in  gold  coin  has  gone  out  of  the  commerce  of  this 
country  into  the  commerce  of  other  countries.     Can  New  York  stand 
this?"— James  G.  Elaine  in  1881. 

(a)  Is  it  likely  that  we  permanently  lost  no  million  dollars  in  gold 
from  our  circulation  because  we  hired  foreigners  to  carry  our  goods  ? 

(b)  Is  it  likely  that  we  even  temporarily  parted  with  that  much  gold 
on  that  account? 

(c)  Is  it  likely  that  as  a  nation  we  should  have  been  richer  if  we 
had  done  this  carrying  of  products  for  ourselves  ? 

7.  "I  don't  see  that  society  as  a  whole  loses  anything  by  the  giving 
of  a  fireworks  exhibition  costing  $1,000.     Of  course  the  people  who  pay 
for  the  fireworks  are  just  so  much  out.     But  then  the  $1,000  goes  to  the 
other  people  who  furnish  the  fireworks  so  that  society  as  a  whole  comes 
out  even."     Criticize. 

8.  "My  numerous  armies  promote  the  circulation  of  money,  and  dis- 
burse impartially  among  the  provinces  the  taxes  paid  by  the  people  of  the 


XIV]  SOME  MONEY  TRUISMS  195 

state." — Frederick  the  Great  justifying  his  wars  in  a  letter  to  D'Alem- 
bert.     (Quoted  from  Bullock.) 

Was  there  anything  in  the  facts  stated  to  offset  the  sacrifices  under- 
gone by  the  people  in  paying  the  taxes? 

9.  "The  summer  boarders  are  a  great  blessing  to  our  little  village; 
because  they  put  into  circulation  a  lot  of  money,  which  means  at  least 
temporary  prosperity." 

What  must  we  understand  this  phrase,  "put  into  circulation  money" 
to  mean,  if  we  accept  the  above  as  anything  like  an  adequate  explana- 
tion of  the  prosperity  brought  by  the  summer  boarders? 

10.  "The  individual  can  get  rich  only  by  selling  more  than  he  buys 
and  saving  the  surplus  in  the  form  of  money  or  bank-credit.     So  a  coun- 
try can  increase  its  wealth  only  by  exporting  more  than  it  imports,  and 
taking  the  difference  in  money."     Discuss  both  parts. 

11.  "I  am  not  convinced  of  the  soundness  of  the  orthodox  doctrine 
that  a  country  can  have  all  the  money  it  wants  and  needs,  just  as  it  can 
have  all  the  engines,  machinery,  etc.,  which  it  wants.     Money  is  very 
different  from  other  things.     It  would  be  easy  to  give  a  man  all  the 
food  and  clothes  he  wants ;  but,  however  much  money  you  offered  him, 
he  would  take  it  all  gladly."     Criticize. 

12.  From  a  Salt  Lake  supporter  of  the  "Seeing  America"  movement: 
"We  recognize  that  Americans  are  annually  spending  $200,000,000  in 
foreign  travel.     That  practically  every  dollar  of  this  vast  sum  is  lost 
to  the  home  circulation  cannot  be  disputed."    Criticize  the  last  sentence. 


CHAPTER  XV 

SAY'S  LAW 

The  preceding  chapter  sought  to  emphasize  certain  elementary 
principles  governing  the  mechanism  of  exchange,  principles  which, 
though  little  more  than  truisms,  are  often  overlooked.  For  exchange 
itself — the  process  of  trade  between  individuals  and  communities- 
there  are  similar  elementary  principles  which  are  so  commonly  neg- 
lected or  misunderstood  as  to  call  for  early  comment.  One  of  these, 
perhaps  the  most  fundamental  of  all,  has  already  been  given  on  page 
33,  in  the  proposition  that  the  chief  function  of  exchange  is  to 
make  cooperation  and  specialization  possible.  In  this  chapter,  we 
consider  a  second  principle  of  this  kind,  one  which  we  shall  desig- 
nate Say's  Law. 

General  Demand  Fallacies. — Among  the  fallacious  notions 
in  popular  thinking  that  have  gained  very  wide  currency  are  to  be 
found  a  number  which  grow  out  of  misconceptions  as  to  the  real 
source  of  the  general  or  total  demand  for  goods,  and  as  to  the 
methods  by  which  that  demand  is  increased  or  diminished.  Several 
types  of  these  fallacious  notions  may  be  cited.  Thus,  governmental 
improvements  of  all  kinds,  including  even  those  of  questionable 
value,  are  often  supported  by  business  men  and  others  on  the  ground 
that  such  improvements  increase  the  total  demand  for  goods.  Catas- 
trophes, such  as  the  San  Francisco  earthquake,  disastrous  fires,  tor- 
nadoes, or  even  only  freezing  weather  which  causes  water  pipes  to 
burst,  are  frequently  accepted  as  evils  not  unmixed  with  good 
inasmuch  as  the  expenditures  necessitated  for  reconstruction  and  re- 
pairs are  supposed  to  increase  the  general  demand.  On  the  other 
hand,  persons  of  thrifty  habits  who  save  a  large  share  of  their  in- 
comes are  frequently  the  objects  of  criticism  on  the  ground  that 
saving  diminishes  the  total  demand  for  goods.  Again,  many  persons 

196 


XV]  SAY'S  LAW  197 

seek  economic  support  for  the  opposition  to  prison  labor,  and  to  the 
employment  of  women  and  children  in  industry,  in  the  argument  that 
such  employment  diminishes  the  number  of  jobs  open  to  laborers 
generally.  Finally,  we  have  the  fears  of  those  who  periodically 
prophesy  universal  overproduction — a  universal  glut.  A  true  under- 
standing of  the  nature  of  the  total  demand  for  goods  will  show  that 
these  notions  are  fundamentally  unsound. 

Their  Argument. — What  is  meant  by  those  who  believe  thav; 
governmental  expenditures  or  destructive  accidents  tend  to  increase 
the  general  demand  for  goods  is  that  they  set  up  chains  of  purchases 
which  would  not  otherwise  be  made,  and,  in  doing  so,  bring  about  an 
increase  in  the  total  demand  for  goods.  Now,  the  trouble  witli  this 
account  of  the  matter  is  that  only  one  half  of  it  is  true.  The  chain 
of  purchases  indicated  is  really  set  up;  but  it  does  not  result  in  the 
increase  in  total  demand  which  is  claimed.  The  case  for  the  chain 
is  evident  enough.  Thus,  take  the  example  of  a  householder  whose 
roof  has  been  blown  off  by  a  severe  storm  or  tornado.  He  at  once 
proceeds  to  buy  shingles  and  hire  carpenters ;  the  carpenters  and  the 
lumber  dealer,  finding  their  incomes  increased,  buy  more  groceries 
and  clothing;  the  grocer  and  clothier  use  their  unusually  large  re- 
ceipts to  improve  their  stocks  by  purchase  from  the  wholesaler,  or 
spend  more  freely  for  pleasure  rides  and  concerts ;  and  so  on.  Thus 
the  purchases  made  by  the  roofless  householder  extend  themselves 
indefinitely  down  the  line,  business  quickens  everywhere,  and  the 
prosperity  of  the  whole  community  seems  to  be  heightened. 

The  Fallacy. — But,  now,  what  about  the  second  half  of  the 
popular  account  of  this  matter?  Does  the  series  of  reactions  which 
all  admit  follows  the  tornado  result  in  an  increase  in  the  total  de- 
mand? The  correct  answer  is  surely  a  negative  one.  The  money 
which  on  account  of  the  tornado  our  householder  was  compelled  to 
spend  putting  on  a  new  roof  would  ultimately  have  been  spent  any- 
how, though  in  some  other  direction ;  and,  being  thus  spent,  it  would 
have  created  just  the  same  demand  for  commodities  or  services.  Thus, 
for  the  sake  of  simplicity,  let  us  suppose  that  our  householder  had 
planned  to  use  the  money  spent  on  the  new  roof  in  putting  a  cellar 


I98  PRINCIPLES  OF  ECONOMICS  [XV 

under  a  part  of  the  house  which  was  hitherto  not  provided  with  this 
convenience.  A  necessary  result,  then,  of  spending  this  money  to 
repair  the  broken  roof  is  to  prevent  it  from  setting  up  another  chain 
of  purchases,  starting  with  those  needed  to  excavate  the  cellar.  This 
other  chain  would  have  begun  with  the  hiring  of  cellar  diggers  and 
the  buying  of  cement;  the  diggers  and  cement  dealers  would  then 
have  spent  more  for  furniture  and  dental  service ;  and  the  furniture 
merchants  and  dentists  in  their  turn  would  have  spent  more  for 
automobiles  and  real  estate.  In  short,  the  purchases  made  by  the 
householder  in  digging  a  new  cellar  would  have  extended  their  in- 
fluence endlessly,  stimulating  business  and  apparently  bringing  pros- 
perity into  the  world,  just  the  same  as  purchases  made  to  repair  a 
roof  whisked  off  by  a  tornado.  Hence  the  tornado  does  not  increase 
demand  in  the  least,  it  merely  substitutes  one  chain  of  purchases  for 
another.1 

Perhaps,  however,  the  objector  may  argue  that  our  householder 
need  not  spent  the  money  at  all.  He  may,  instead,  put  it  into  a  bank. 
Truly ;  but  then  money  that  is  put  into  a  bank  is  not  kept  there.  It 
is  loaned  out  to  people  who  need  it  to  meet  immediate  expenses  or 
who  wish  to  increase  the  capital  which  they  are  employing  in  their 
business.  In  any  case,  they  are  people  who,  after  borrowing  the 
money,  will  surely  use  it  to  buy  goods  of  some  kind,  and  so  will 
increase  the  general  demand  just  as  much  as  did  spending  that 
money  to  put  on  a  new  roof. 

Demand  Coincident  with  Income. — What,  now,  is  the  gen- 
eralization to  be  made  from  the  story  of  our  house  owner?  Imme- 
diately, it  is  this :  The  contribution  made  by  any  one  person  to  the 
total  demand  for  goods  is,  in  the  long  run,  bound  to  be  just  equal 
to  his  income,  no  more  and  no  less.  He  cannot  demand  more  goods 


1  Incidentally,  too,  we  should  note  that,  from  the  standpoint  of  the  original 
householder,  the  chain  of  purchases  which  would  have  been  started  by 
digging  a  cellar  is  much  more  desirable  than  the  one  actually  started  by 
repairing  the  roof.  The  second  process  leaves  the  man  with  a  house  no 
better  than  before — a  house  having  a  roof  but  no  cellar.  The  first  would 
have  left  him  a  house  already  sufficiently  well  roofed,  and  improved  by  the 
addition  of  a  cellar.  Hence,  while  business  in  general  gains  nothing  from 
the  tornado,  the  householder  suffers  a  positive  loss. 


XV]  SAY'S  LAW  199 

than  that  income  will  buy ;  he  or  someone  who  borrows  his  money 
is  certain  to  demand  as  large  a  quantity  as  that  income  will  buy. 

Demand  Coincident  with  Product. — But  this  only  starts  us 
on  our  way.  What  determines  the  quantity  of  his  money  income? 
Broadly  speaking,  this  is  determined  by  the  amount  of  goods  or 
services  which,  under  existing  legal  conditions,  is  credited  to  him  as 
his  product,2 — it  being  assumed  that  he  is  producing  something  de- 
manded and  producing  that  something  in  the  proper  proportion  to 
other  goods  produced.  It  follows  that  the  contribution  to  total  de- 
mand made  by  anyone  is  necessarily  equal  to  the  quantity  of  his 
product;  it  cannot  be  greater;  it  must  be  as  great.  Finally,  since  the 
total  demand  of  a  community  necessarily  consists  of  the  sum  of  the 
demands  made  by  the  individuals  who  constitute  the  community,  the 
total  demand  of  that  community  must  equal  its  total  product;  it  can- 
not be  greater ;  it  is  bound  to  be  as  great.  But  these  propositions  are 
so  important  that  they  must  be  more  specifically  defended. 

Demand  Not  Greater  than  Product. — Demand  cannot  be 
greater  than  product, — cannot,  at  bottom,  include  anything  outside 
of  product.  Imagine  a  shoemaker  who  makes  nothing  but  shoes 
desiring  to  obtain  a  quantity  of  wheat  from  a  wheat  farmer  who 
raises  no  other  grain.  Obviously,  the  only  way  he  can  hope  to 
obtain  wheat  is  to  offer  shoes — either  directly  on  the  barter  plan, 
or  indirectly  through  a  money  medium — in  exchange.  But  these 
shoes  which  he  offers  he  must  first  have  produced — they  are  a 
product;  hence  the  shoemaker's  demand  for  wheat  cannot  include 
anything  outside  of  his  product  (shoes).  Reversing  the  hypothesis, 
if  the  wheat  grower  desires  a  new  pair  of  shoes,  his  demand  for 
shoes  cannot  include  anything  outside  of  his  own  product  (wheat)  ; 
he  simply  has  nothing  else  to  demand  with.  Now,  if  this  is  true 
of  two  people  in  their  relation  to  each  other,  it  must  be  equally 


3  This  is  not  to  be  taken  as  meaning  that  the  individual  is  morally  entitled 
to  the  particular  income  which  he  is  receiving  on  the  ground  that  he  produces 
it.  The  product  is  here  whether  or  not  the  right  man  is  credited  with  it; 
and  the  value  of  that  product  determines  the  volume  of  demand  resulting, 
whoever  ought  to  control  that  demand. 


200  PRINCIPLES  OF  ECONOMICS  [XV 

true  of  one  person  in  his  relation  to  society  as  a  whole :  the  demand 
made  by  shoemakers  for  market  goods  of  all  kinds  can  include 
nothing  but  shoes  produced  by  them  and  offered  on  the  market; 
the  demand  made  by  wheat  growers  for  market  goods  of  all  kinds 
can  include  nothing  but  wheat  produced  by  them  and  offered  on 
the  market — in  each  case  nothing  else  will  serve  as  a  demand  for 
goods  in  general  except  something  which  the  individual  has  himself 
produced.  Finally,  this  proposition,  being  true  of  every  individual, 
must  be  true  of  all  individuals  taken  together.  The  demand  of  all 
the  people  in  the  community,  the  total  demand,  can  be  no  greater 
than  the  product  of  all  the  people  of  the  community,  the  total  product. 
Finally,  what  is  true  of  each  nation  in  its  relations  with  the  rest 
of  society,  is  equally  true  of  all  society,  of  the  whole  world,  in  its 
complex,  intricate  relations  with  itself.  The  demand  made  by  all 
society  for  market  goods  of  all  kinds  can  include  nothing  but  goods 
•which  the  same  society  has  produced  and  offered  on  the  market. 

Demand  as  Great  as  Product. — Demand  must  be  as  great 
as  product,  must  include  all  of  the  goods  produced  for  the  market — 
assuming  that  producers  have  directed  their  production  in  true  accord 
with  one  another's  wants. 

It  goes  without  saying  that  all  goods  produced  for  the  market 
will  be  offered  in  exchange,  that  being  the  purpose  of  their  pro- 
duction ;  and,  by  being  offered  in  exchange  all  these  goods  come  to 
constitute  a  demand  for  other  goods,  in  so  far  as  this  matter  is 
determined  by  the  purpose  of  their  producers.  Thus,  if  the  shoe- 
maker produces  and  puts  on  the  market  each  year  two  hundred 
pairs  of  shoes,  then,  as  far  as  his  intent  goes,  every  one  of  these 
shoes  constitutes  a  demand  for  bread,  or  meat,  or  clothing,  or  some 
other  good  which  the  shoemaker  needs.  What  is  true  of  the  in- 
dividual is  obviously  true  of  the  aggregate  of  individuals  also.  All 
the  goods  which  they  all  produce  constitute  a  demand  for  goods,  in 
so  far  as  the  purpose  of  the  producer  affects  this  matter. 

But  we  have  yet  to  deal  with  the  proviso  "in  so  far  as  this 
matter  is  determined  by  the  purpose  of  their  producers."  This 
proviso  is  needed  because  the  question  whether  or  not  a  product 
shall  form  a  part  of  demand  depends  not  only  on  the  attitude  of 


XV]  SAY'S  LAW  201 

the  producer  of  that  product,  but  also  on  the  attitude  of  those  per- 
sons who  must  be  depended  on  to  buy  said  product.  For  demand 
involves  not  only  a  desire  on  the  part  of  the  prospective  buyer,  but 
also  buying  power ;  and  buying  power  can  be  derived  from  products 
one  has  to  sell  only  on  condition  that  other  people  want  those 
products,  as  well  as  have  the  power  to  offer  other  goods  in  exchange 
for  them.  It  follows  that  a  particular  product  comes  to  constitute 
a  part  of  the  total  demand  for  goods  only  in  so  far  as  it  is  a  product 
for  which  there  is  a  corresponding  demand.  For  example,  the 
two  hundred  pairs  of  shoes  of  our  shoemaker  constitute  a  part  of 
the  total  demand  for  goods  only  on  condition  that  they  are  goods 
which  other  people  demand, — stand  ready  to  buy.  And  this  implies, 
it  should  be  noted,  that  the  product  in  question  is  demanded  in  the 
proportion  in  which  it  is  produced — when  we  produce  a  thing  we 
do  not  add  to  demand  in  proportion  to  the  volume  for  our  product 
unless  we  are  maintaining  the  proper  proportion  between  our 
products  and  other  products. 

The  points  just  brought  out  with  respect  to  the  relation  between 
demand  and  the  output  of  goods  are  so  evident  that  some  will  con- 
sider it  scarcely  legitimate  to  give  them  the  dignity  derived  from 
formal  statement.  On  the  other  hand,  the  continued  prevalence 
throughout  the  larger  part  of  the  community  of  the  fallacious  no- 
tions which  these  considerations  are  designed  to  correct  seems  to 
furnish  ample  ground  for  any  procedure  which  gives  these  points 
adequate  emphasis.  I  shall  therefore  put  the  proposition  we  have 
discussed  in  the  form  of  a  principle.  This  principle,  I  have  taken 
the  liberty  to  designate  Say's  Law ;  because,  though  recognized  by 
many  earlier  writers,  it  was  particularly  well  brought  out  in  the 
presentation  of  Say  (1803).  This  principle  may  be  stated  as 
follows : 

Principle  — Say's  Law.  The  Ultimate  Identity  of 
Demand  and  Product. 

In  the  last  analysis,  the  demand  for  goods  produced  for 
the  market  consists  of  goods  produced  for  the  market,  i.  e., 
the  same  goods  are  at  once  the  demand  for  goods  and  the 
supply  of  goods;  so  that,  if  we  can  assume  that  producers 


202  PRINCIPLES  OF  ECONOMICS  [XV 

have  directed  production  in  true  accord  with  one  another's 
wants,  total  demand  must  in  the  long  run  coincide  with  the 
total  product  or  output  of  goods  produced  for  the  market. 

Say's  Law  a  Long-Run  Principle. — In  the  case  of  sciences 
— even  physical  sciences— which  deal  with  highly  complicated 
phenomena,  many  principles  have  to  be  affirmed  as  true  in  the  long 
run ;  and  this  frequently  applies  to  the  science  of  economics.  Thus, 
everyone  knows  that  the  prices  of  goods  tend  to  equal  their  cost 
of  production;  but  everyone  also  knows  that  changes  in  cost  do 
not  immediately  cause  corresponding  changes  in  price.  Now,  this 
comment  is  applicable  to  Say's  Law  to  a  more  than  usual  degree. 
For  this,  there  is  one  very  substantial  reason.  It  is  this :  save  under 
the  most  primitive  conditions,  every  exchange  of  product  for  product 
is  broken  into  two  parts — (i)  exchanging  one's  own  product  for 
money  or  bank  credits,  and  (2)  exchanging  the  money  or  bank 
credits  thus  obtained  for  the  product  of  the  other  man.  Obviously, 
an  interval  of  time  can  be  put  between  these  two  operations ;  and, 
as  a  matter  of  fact,  such  an  interval,  short  or  long,  almost  always 
intervenes. 

It  follows  from  the  facts  just  brought  out  that  it  is  possible 
for  us  to  postpone  for  a  long  period,  even  indefinitely,  the  second 
part  of  the  operation,  thus  cutting  down  for  the  time  being  the 
general  demand  for  goods,  though  we  have  not  cut  down  the  amount 
of  production.  On  the  other  hand,  it  is  possible  that,  by  getting 
possession  of  the  medium  of  exchange,  money  or  bank  credits,  in 
ways  other  than  by  exchanging  our  goods  for  that  medium  of  ex- 
change, we  should  perform  the  second  half  of  the  exchange  opera- 
tion before  having  performed  the  first  half.  In  this  way  demand 
may  be  increased  enormously,  though  production  has  not  been  in- 
creased at  all. 

The  qualification  of  Say's  Law  made  necessary  by  this  peculiar- 
ity of  money  exchange  has  little  if  any  bearing  on  the  use  of  that 
principle  to  correct  the  fallacious  notions  which  were  used  to 
illustrate  this  discussion.  But  there  are  a  number  of  matters  in 
respect  to  which  this  limitation  on  Say's  Law  is  of  much  im- 
portance. One  of  the  lesser  of  these  is  closely  connected  with 


XV]  SAY'S  LAW  203 

one  of  those  fallacious  notions  which  were  brought  forward  in 
the  earlier  part  of  this  chapter,  namely:  the  idea  that  by  increasing 
governmental  expenditure  we  can  increase  the  total  demand  for 
goods  and  so  increase  general  prosperity.  Such  a  device,  looked 
at  as  something  to  be  made  use  of  in  ordinary  times  when  economic 
affairs  are  running  along  in  normal  fashion,  is,  from  the  standpoint 
of  sound  economic  science,  quite  impracticable.  It  could  do  nothing 
more  than  deflect  demand  from  some  lines  of  production  to  other 
lines  of  production. 

But  the  case  is  very  different  if  circumstances  have  brought  us 
to  a  point  where  the  first  of  the  discrepancies  between  demand  and 
output  noted  above  has  become  quite  general, — that  is,  a  point 
where  buyers  generally  are  suspending  the  second  half  of  the  ex- 
change operation.  Such  a  procedure  means  a  general  decline  in 
demand,  hence  of  necessity  a  general  slackening  of  productivity  all 
along  the  line.  A  situation  like  this  is  characteristic  of  the  depression 
which  follows  a  business  crisis.  If,  now,  under  such  a  condition 
of  things,  the  public  authorities  step  in  and  undertake  a  large  pro- 
gram of  road-making  or  building  construction  or  harbor  improve- 
ments, this  will  really  mean  a  considerable  increase  in  total  demand 
and  so  an  increase  in  general  prosperity.3 

Much  more  important  cases  where  the  practice  of  breaking  the 
exchange  operation  into  two  parts  makes  possible  a  change  in  the 
volume  of  demand  in  general  which  is  not  preceded  by  a  change  in 
the  output  of  goods  in  general,  arise  in  connection  with  the  phenome- 
non of  money  and  credit.  But  these  are  not  suited  for  consideration 
at  this  stage  in  our  economic  study. 

ILLUSTRATIVE  PROBLEMS 

i.  "George  Rankin  is  of  course  a  big  fool  to  spend  $400  making 
a  mill  dam  in  a  creek  which  is  dried  up  every  summer  and  never  has 
enough  water  to  run  an  ice  cream  freezer ;  but  he  is  doing  one  good  thing, 
— he  is  making  a  whole  lot  more  demand  for  labor  and  so  a  lot  more 
employment  for  laborers." 

Explain  fallacy. 


3  It  may  even  be  the  beginning  of  a  general  revival  of  business. 


204  PRINCIPLES  OF  ECONOMICS  (XV 

2.  "There  is  just  so  much  work  to  be  done.     The  entrance  of  women 
and  children  into  the  field  of  labor  must  drive  out  an  equal  amount  of 
adult  male  labor." 

Criticize.  (There  are  no  doubt  objections  of  real  weight  to  the  ex- 
tension of  child  and  female  labor;  but  this  is  not  one  of  them.) 

3.  "The  real  cause  of  the  present  standstill  in  trade  is  the  inequality 
of  incomes.     There  can  be  no  effective  demand,  because  those  who  have 
the  money  to  buy  have  no  unsatisfied  wants,  while  those  who  have  the 
wants  have  no  power  to  buy."     Criticize. 

4.  In  a  certain  part  of  a  recent  novel,  Mr.  Blossom,  a  young  painter 
and  decorator,  is  trying  to  induce  Miss  Cynthia  to  give  him  a  job  re- 
decorating her  house,  which  is  somewhat  behind  the  times  in  this  respect. 
The  latter  part  of  the  conversation  on  the  matter  is  as  follows: 

"  'Live  and  let  live'  is  a  good  enough  motto  for  me." 
"  'Live  and  let  live/  "  repeated  Miss  Cynthia,  thoughtfully.     "What 
do  you  think  that  means?" 

"Why,  it's  plain  enough,"  said  Mr.  Blossom,  strongly.  "You're  living 
all  right,  ain't  you  ?  Got  enough  of  everything  and  something  to 
spare  .  .  .  ;  but  you've  got  to  let  other  folks  live.  ...  If  there's  any- 
thing you  want  done  that  you  can't  do  for  yourself,  hire  somebody  that 
can  do  it  ...  so  they  can  live,  too.  If  everybody  did  that  right  along, 
I  guess  there  wouldn't  be  so  much  talk  about  labor  unions  and  strikes  and 
all  that  sort  of  thing." 

(a)  Would  Miss  Cynthia's  deciding  to  spend  and  actually  spending 
$600  to  redecorate  her  house  increase  the  employment  of  laborers  gen- 
erally? 

(b)  Why  can  we  be  certain  that  everybody  is  now  doing  the  thing 
which  Mr.  Blossom  thinks  they  ought  to  be  doing? 

5.  Street  comment  on  a  cold  snap  which  bursts  numerous  water- 
pipes:     "Hard  on  householders,  sure  enough;  but  no  great  loss  without 
some  small  gain.     It's  a  bonanza  for  Ann  Arbor  plumbers."     Is  that 
sound  ? 

6.  Mr.  A,  having  earned  and  saved  $10,000  in  gold,  buries  it  in  the 
ground.     Another,   having   earned  and  saved  $10,000,   spends   it   on  a 
great  banquet.     Which  makes  the  greater  demand  for  products  ?     Ex- 
plain. 

7.  Would  we  naturally  expect  events  like  the  San  Francisco  earth- 
quake and  fire  to  increase  the  demand  for  labor  in  general?     Explain. 


XV]  SAY'S  LAW  205 

8.  "Economically  it  is  for  the  interest  of  every  class  of  producers 
to  see  the  efficiency  of  other  classes  of  producers  increase."     Why  ? 

9.  "The  extraordinary  advance  in  industrial  technique  characteristic 
of  the  last  half  century  has  so  increased  our  productive  capacity  that, 
when  things  are  running  smoothly,  output  is  bound,  sooner  or  later,  to 
exceed  demand,  which  condition  of  things  invariably  leads  to  a  com- 
mercial crisis  followed  by  a  general  collapse  of  industry."     Criticize. 

10.  The  Chicago  Record-Herald  for  April  18,  1908,  contained  the 
report  of  an  interview  with  the  head  of  one  of  America's  great  univer- 
sities, wherein  various  opinions  and  statements  were  attributed  to  King 
Haakon  of  Norway.  Among  these  was  the  following:  "I  could  black 
my  own  boots  if  I  wished  to ;  I  have  done  it  and  therefore  know  how ;  but 
if  I  did,  what  would  become  of  the  people  who  make  a  living  blacking 
boots  ?" 

Criticize  on  the  basis  of  Say's  Law. 


CHAPTER  XVI 

THE  PRINCIPLE  OF  RECIPROCITY 

The  Buy-Little  Fallacy. — One  of  the  most  persistent  and 
widespread  of  errors  with  respect  to  economic  matters  is  that,  in 
the  trade  between  countries,  the  condition  of  maximum  desirability 
is  to  be  always  selling,  never  buying,  or  anyhow  selling  as  much 
more  than  we  buy  as  is  possible.  Almost  every  year  our  foreign 
trade  reports  seem  to  show  a  great  excess  .of  exports;  and  this 
announcement  always  brings  out  a  chorus  of  congratulatory  com- 
ments from  our  press.1  Now  it  is  quite  certain  that  such  one- 
sidedness  in  trade — selling  without  buying — would  be  in  the  highest 
degree  undesirable,  if  it  were  feasible.  It  would  not  be  for  our 
advantage  to  sell  more  than  we  buy.  But,  further,  it  is  quite 
certain  that  such  one-sided  trade  would  not  be  feasible,  supposing 
it  to  be  desirable.  Generally  speaking,  it  is  not  possible  for  us  to 
sell  more  than  we  buy, — our  exports  cannot  exceed  our  imports. 
The  second  of  these  propositions  is  more  especially  the  principle  with 
which  we  are  here  concerned ;  but  some  comment  on  the  first  seems 
called  for. 

Not  Desirable. — In  showing  that  selling  without  buying 
would  not  be  desirable,  it  will  perhaps  be  best  to  start  from  the 
standpoint  of  individual  trade.  That  such  trade  would  not  be  de- 
sirable for  the  individual  is  almost  self-evident;  for  this  proposition 
necessarily  follows  from  the  very  function  for  which  trade  exists. 
That  function,  as  fully  explained  in  our  general  account  of  the 


1  As  will  be  explained  in  a  latter  connection,  there  are  times  when,  in 
view  of  the  relation  of  foreign  trade  to  another  matter — the  stability  of  the 
monetary  system — it  is  desirable  to  have  an  export  trade  balance.  For  this 
reason,  there  is  at  times  some  propriety  in  thinking  of  such  a  balance  as  a 
favorable  one.  But  this  is  not  what  the  general  public  have  in  mind  when 
accounting  every  such  balance  favorable. 

206 


XVI]  PRINCIPLE  OF  RECIPROCITY  207 

present  economic  order,  is  to  consummate  and  therefore  to  make 
possible  that  cooperation  between  us  and  our  fellows  which  is 
so  essential  to  high  productive  efficiency.  But  obviously  such  co- 
operation would  not  be  accomplished  unless  each  bought  as  well  as 
sold.  The  advantage  which  each  derives  from  cooperation  is  de- 
pendent on  getting  the  products  of  others,  that  is,  buying.  Selling 
his  own  products  is  of  no  significance  to  him  except  as  it  is  a 
preliminary  to  buying  the  products  of  others. 

But  the  reader  may  be  disposed  to  object  that  some  exceptions 
to  this  account  of  the  matter  must  be  admitted.  First,  the  seller 
may  be  a  miser  who  only  desires  to  heap  up  stores  of  gold,  not 
caring  for  goods  at  all,  or  anyhow  not  caring  for  any  goods  in 
excess  of  the  absolute  necessities  of  life.  Secondly,  the  seller  may 
be  a  prospective  capitalist,  one  who  is  accumulating  surplus  wealth 
in  order  to  get  from  it  an  income,  and  who,  therefore,  saves  the 
money  he  gets  from  the  sale  of  his  goods,  instead  of  buying  other 
goods. 

The  first  of  these  objections  is  easily  answered  as  being  only  a 
seeming  exception.  The  miser  is  really  buying  something, — only  in 
his  case,  that  something  is  money.  That  is,  in  his  thought  money 
is  not  really  money — the  medium  of  exchange — but  a  commodity, 
the  particular  commodity  which  his  perverted  taste  leads  him  to 
desire  rather  than  the  kinds  of  commodities  most  men  desire. 

The  unsoundness  of  the  second  exception  is  almost  equally 
evident.  It  is  hardly  even  a  seeming  exception.  The  person  who 
is  accumulating  capital  is  merely  postponing  the  buying  half  of  the 
transaction, — a  thing  every  one  has  to  do  when  buying  expensive 
goods,  in  that  he  has  to  get  together  from  different  sales  enough 
money  to  cover  the  larger  amount  of  money  needed  to  make  the 
particular  purchase  in  question.  In  the  end,  the  capitalist  buys 
goods  or  lends  to  someone  else  who  buys  goods.  If  he  pursues  the 
former  policy,  the  only  peculiarity  of  his  case  is  that  he  buys  a 
different  kind  of  goods  from  those  bought  by  other  people,  namely 
producers'  goods — goods  used  in  the  making  of  other  goods.  Doubt- 
less his  decision  to  save  his  money  until  he  has  enough  to  buy 
goods  of  this  sort  is  of  much  importance, — may  alter  greatly  the 
course  of  things;  but  it  does  not  mean  that  the  money  he  obtains 


208  PRINCIPLES  OF  ECONOMICS 

from  the  sale  of  his  goods  is  not  used  for  buying  other  goods, — 
that  the  second  half  of  the  exchange  transaction  is  left  incomplete.2 
The  case  is  not  materially  different  if  our  capitalist  lends  his  ac- 
cumulations. The  borrower  will,  of  course,  use  those  accumulations 
to  buy  goods.  Thus,  in  the  end,  the  buying  half  of  the  transaction 
which  began  with  the  original  sale  will  finally  be  consummated. 

Not  Feasible. — We  have  seen  that,  in  the  case  of  trade  be- 
tween individuals,  selling  without  buying  could  be  of  no  advantage, 
would  not  be  desirable,  if  feasible.  That  such  one-sided  trade 
would  not  be  feasible  is  quite  as  certain.  We  are  not  able  to  sel) 
without  buying;  reciprocity  is  inherent  in  trade;  buying  and  selling 
mutually  condition  each  other.  The  truth  of  this  proposition  is 
obvious  in  the  case  of  direct  exchange,  barter.  Unless  I  accept  the 
goods  of  the  other  man,  I  get  no  pay  for  my  own.  But  our  proposi- 
tion is  no  less  true  when  barter  is  broken  into  two  parts,  sale  and 
purchase.  First,  the  man  who  buys  from  me  must  be  able  to  sell 
to  some  one  in  order  to  get  the  means  to  pay  for  his  purchase  from 
me.  Secondly,  this  is  feasible  only  provided  I  make  purchases 
from  him  or  from  some  person  or  persons  with  whom  he  is  directly 
or  indirectly  connected  in  trade, 

Trade  Must  Be  Reciprocal. — The  former  of  these  two  propo- 
sitions is  so  evident  that  it  needs  no  discussion.  The  second,  how- 
ever, may  not  at  once  command  assent.  For,  at  first  thought,  the 
reader  may  be  disposed  to  say:  True,  someone  must  buy  from 
my  customer,  else  he  cannot  get  the  means  to  pay  me ;  but  it  is  not 
necessary  that  I  should  be  that  someone ;  another  customer  will 
answer  just  as  well.  Doubtless  the  statement  is  quite  true  as  far 
as  it  goes;  but  it  does  not  meet  the  difficulty.  Mr.  B  who  buys 
from  me  may  have  obtained  the  means  of  payment  by  selling  his 
product  to  Mr.  C;  in  turn,  Mr.  C  may  have  obtained  the  means 


*  Some  care  is  needed  in  using  or  interpreting  the  word  "spend."  While 
there  is  no  impropriety  in  attaching  to  the  term  the  idea  that  the  goods  for 
which  the  money  is  given  are  not  very  necessary,  are  even  goods  which 
under  all  the  circumstances  we  would  better  do  without,  we  must  not  let 
ourselves  drift  into  thinking  that  money  paid  out  for  necessary,  approved, 
goods  is  not  just  as  truly  spent,  if  we  mean  "parted  with,"  used  to  buy 
something. 


XV11  PRINCIPLE  OF  RECIPROCITY  209 

of  payment  for  his  purchase  from  B  by  selling  his  product  to  Mr. 
D ;  in  turn,  Mr.  D  may  have  obtained  the  means  of  payment  for  his 
purchase  from  C  by  selling  to  Mr.  E;  and  so  on  until  the  last 
man  in  the  world  other  than  myself  has  been  brought  into  the  chain. 
But  that  last  man  must  be  able  to  sell  to  me  in  order  to  forge  the 
first  link  in  the  chain  which  ends  in  purchases  from  me. 

In  order  to  make  this  point  clear  beyond  question,  let  us  give 
it  concrete  illustration  on  the  basis  of  an  extravagantly  simple 
hypothesis  as  follows :  Our  trading  is  limited  to  four  persons  whom 
we  will  designate  A,  B,  C,  and  D,  respectively.  Each  sells  all 
his  product  to  one  other  member  of  the  group ;  each  also  makes  all 
his  purchases  from  one  member  of  the  group,  this  time  a  different 
one;  and  each  produces  and  exchanges  $10,000  worth  of  goods. 
Let  us  now  conceive  one  of  the  four,  A,  to  be  set  over  against 
the  other  three,  and  try  to  show  that,  if  he  would  sell,  he  must  also 
buy.  Let  us  suppose  that  B  stands  ready  to  take  A's  $10,000  worth 
of  products;  C  to  take  B's  $10,000  worth;  and  D  to  take  C's 
$10,000  worth;  while  A,  by  the  original  hypothesis,  is  determined 
only  to  sell,  never  to  buy.  What  result  must  follow  ?  Plainly  there 
is  no  one  to  whom  D  can  dispose  of  his  $10,000  worth  of  products; 
he,  therefore,  cannot  buy  those  of  C,  though  he  desires  to  do  so. 
As  a  result,  C  cannot  buy  those  of  B ;  and  finally,  B  cannot  buy 
those  of  A.  Thus  all  exchange  is  stopped  because  A  makes  no 
purchases.  Let  him  reverse  his  policy,  and  all  difficulty  at  once 
disappears.  If  A  will  buy  the  goods  of  D,  the  latter  will  have 
the  means  to  buy  the  goods  of  C,  who  will  then  have  the  means  to 
buy  the  goods  of  B,  who  will  then  have  the  means  to  buy  the 
goods  of  A. 

Inter-Group  Trade  Must  Be  Reciprocal. — The  above  argu- 
ment to  show  that  trade  between  individuals  must  be  reciprocal, 
that  we  must  buy  if  we  would  sell,  was  only  preliminary  to  our  real 
task — to  show  that  trade  between  communities,  countries,  must  be 
reciprocal, — purchases  and  sales,  imports  and  exports,  must  balance. 
Before  getting  into  this  task,  however,  we  must  take  a  moment  to 
make  more  definite  and  precise  just  wJiat  is  meant  by  the  thesis 
defended. 


210  PRINCIPLES  OF  ECONOMICS  [XVI 

First,  the  contention  is  that  our  foreign  trade  must  show  equality 
between  purchases  and  sales,  imports  and  exports  of  services  and 
goods,  not  including  money.  In  general,  the  money  of  a  country 
is  a  necessary  part  of  its  economic  equipment  which  it  can  no  more 
spare,  save  for  a  very  brief  period,  than  a  household  could  spare 
its  cook  stove  or  beds.  Doubtless  a  country  may  for  a  time  use 
its  money  stock  to  make  purchases  for  which  an  altogether  excep- 
tional need  has  risen ;  but,  generally  speaking,  such  a  policy  will  not, 
cannot,  be  continuous.  To  this  exclusion  of  money  from  the  list 
of  exports  and  imports  to  be  equalized,  however,  one  exception 
must  be  pointed  out.  Standard  money  is  usually  a  metal  product ; 
and  a  product  of  very  uneven  distribution  in  respect  to  production. 
A  few  countries  mine  practically  all  the  gold  of  the  world.  This 
being  true,  most  countries  must  import  their  supplies  of  money 
metal,  which  obviously  means  that  the  producing  countries  must 
export  that  metal.  But,  again,  this  particular  product  is  commonly 
marketed,  not  as  a  metal,  but  as  money.  Producers  sell  it  directly  to 
mints  or  assay  offices  or  to  banks  which  dispose  of  it  to  mints  or  per- 
haps at  once  treat  it  as  international  money.  It  follows  that  the 
distribution  of  gold  from  producing  to  non-producing  countries 
will  largely  take  the  form  of  moving  money  (frequently  gold  in  bar 
form)  from  the  former  to  the  latter.  Accordingly,  it  is  to  a  certain 
extent  necessary  to  include  as  a  part  of  the  exports  or  imports  of 
a  country,  money  sent  out  or  brought  in.  This  exception,  however, 
is  commonly  of  little  importance,  save  when  the  producing  country 
has  almost  no  other  product,  for  example,  the  Klondike. 

Real  Exports  and  Imports. — A  second  point  with  respect  to 
the  proposition  that  exports  and  imports  must  be  equal,  which  needs 
to  be  noted,  is  that  the  exports  and  imports  had  in  mind  are  the 
real,  the  true,  exports  and  imports,  not  those  reported  by  the  customs 
authorities.  The  latter  are  seldom  if  ever  equal,  though  the  former 
must  be.  The  explanation  is  easy.  Customs  reports  do  not,  and 
cannot,  show  all  exports  and  imports.  Thus,  the  true  imports  of  a 
country  obviously  include  everything  bought  by  its  people  from  the 
people  of  other  countries.  But  some  of  these  things  bought  from 
other  countries  cannot,  or  at  least  do  not,  come  to  the  knowledge 


XVI]  PRINCIPLE  OF  RECIPROCITY  211 

of  government  officials.  Of  these  the  most  important  are  (i)  goods 
and  services  bought  from  the  foreigner  in  his  own  country,  e.g., 
by  our  people  traveling  there,  and  (2)  services  bought  from  the 
foreigner  and  delivered  in  our  own  country,  but  not  appearing  in 
import  lists  because  as  services  they  do  not  go  through  the  custom 
house.  In  short,  there  are  invisible,  as  well  as  visible,  imports ;  and 
it  is  the  sum  of  both  of  these  which  must  be  equal  to  the  total  of 
exports.  What  has  been  said  of  imports  applies  of  course  to 
exports.  Of  these  some  are  visible,  some  invisible;  and  it  is  their 
sum  which  must  equal  the  total  imports. 

Accordingly,  if  we  wish  to  get  a  correct  balance  sheet  of  the 
exports  and  imports  of  a  country,  we  must  add  to  the  figures  fur- 
nished us  by  the  customs  officials,  figures  from  other  sources — 
mostly  mere  estimates — taking  into  account  these  invisible  exports 
and  imports.  Thus,  if  it  is  true,  as  some  say,  that  we  get  trans- 
portation done  for  us  by  other  nations  to  the  value  of  $200,000,000 
per  year,  we  must  enter  on  the  import  side  of  the  balance  sheet  an 
item  like  this : 

Services  of  Carriers $200,000,000 

So,  if  it  is  true  that  we  use  capital  borrowed  from  other  countries 
to  an  amount  which  calls  for  $120,000,000  of  interest  per  year,  then 
we  must  enter  on  the  import  side  this  item : 

Services  of  Borrowed  Capital $120,000,000 

or,  in  the  more  usual  form: 

Interest  of  Borrowed  Capital $120,000,000 

I  hardly  need  add  that  the  countries  selling  us  these  services  would 
have  to  make  similar  entries  on  the  export  side  of  their  balance 
sheets. 

Total  Exports:  Total  Imports. — As  a  final  comment  in  in- 
terpreting the  Principle  of  Reciprocity,  we  note  that  the  equality 
of  exports  and  imports  which  is  declared  to  be  necessary  is  equality 


212  PRINCIPLES  OF  ECONOMICS  [XVI 

between  the  exports  of  a  country  to  all  other  countries  and  its 
imports  from  all  other  countries, — not  equality  between  its  exports 
to  each  country  and  its  imports  from  that  same  country.  We  buy 
from  England  much  less  than  we  sell  to  her;  but,  then,  we  buy 
from  some  other  countries  to  which  England  sells  an  excess  of 
goods,  much  more  than  we  sell  to  them.  In  conventional  language, 
international  trade  is  triangular.  More  precisely,  it  is  multiangular. 
But,  however  many  angles  it  may  show,  the  total  in  must  equal 
the  total  out. 

Argument  for  the  Principle. — So  much  for  the  proper  inter- 
pretation of  the  Principle  of  Reciprocity.  We  must  now  add 
the  argument  on  which  that  principle  rests.  Perhaps  the  simplest 
proof  is  analogous  to  that  used  in  establishing  the  same  principle 
as  applicable  to  the  trade  between  individuals.  That  is,  each  must 
buy  as  well  as  sell,  since  otherwise  the  rest  will  not  have  the  means 
to  buy  from  it.  Thus,  let  us  suppose  that  the  A,  B,  C,  and  D 
of  our  illustration  on  page  210  represent  different  countries.  Now, 
as  before,  it  is  possible  that  each  country  should  buy  from  some 
country  other  than  the  one  to  which  it  sells.  It  must,  however, 
buy  from  some  other  country;  since  otherwise  some  member  of 
the  series  will  not  have  the  means  with  which  to  make  the  purchases 
necessary  to  complete  the  series.  It  is  not  possible  for  Country 
A  to  be  just  a  seller,  not  a  buyer.  It  must  buy  from  Country  D, 
in  order  that  D  should  be  able  to  buy  from  C,  in  order  that  C 
should  be  able  to  buy  from  B,  in  order  that  B,  should  be  able  to 
buy  from  A  itself. 

Inequality  of    Exports    and    Imports    Self-Corrective. — We 

have  shown  that  the  foreign  trade  of  a  country  must  be  two-sided 
on  the  ground  that  only  so  can  those  to  whom  that  country  sells 
have  the  means  to  pay  for  their  purchases.  A  more  difficult,  but 
perhaps  more  adequate,  proof  is  that  inequality  between  the  exports 
of  a  country  and  its  imports  is  self -destructive, — that  this  fact  of 
itself  sets  up  reactions  tending  to  bring  about  equality  of  exports 
and  imports,  so  that  equilibrium  cannot  be  established  until  such 
equality  of  exports  and  imports  has  been  secured. 


XVI]  PRINCIPLE  OF  RECIPROCITY  213 

Through  Rate  of  Exchange. — The  first  of  the  reactions  tend- 
ing to  bring  about  the  result  indicated  is  the  effect  produced  on 
the  course  of  trade  through  the  particular  rate  of  exchange  made 
to  prevail  by  an  excess  of  exports  on  the  one  hand,  or  by  an  excess 
of  imports  on  the  other.  As  we  will  remember  from  the  chapter 
on  Credit  Exchange,  the  means  of  payment  (the  medium  of  ex- 
change) in  foreign  trade  is  credit,  the  right  to  claim  money  in  other 
countries, — exchange,  as  it  is  technically  named.  It  follows  that  the 
export  dealers  of  any  country  will  have  such  exchange  to  sell ;  while 
importers  will  need  to  buy  such  exchange.  As  a  consequence,  a 
falling  rate  of  exchange  will  tend  to  lower  the  profits  of  exporters, 
since  the  exchange  they  have  to  dispose  of  brings  in  less;  while  that 
same  falling  rate  will  tend  to  raise  the  profits  of  importers,  since 
the  exchange  they  need 'to  buy  will  come  cheaper.3  But  any  cause 
which  lowers  the  profits  of  exporters  and  raises  those  of  importers 
will  obviously  tend  to  diminish  the  dealings  of  the  former  and  in- 
crease those  of  the  latter,  that  is,  will  tend  to  diminish  exports  and 
increase  imports.  Finally,  an  excess  of  exports  is  just  the  cause 
which  tends  to  lower  the  rate  of  exchange ;  since  such  excess  means 
that  there  is  more  exchange  offered  for  sale  than  the  demand  will 
take  up.  It  thus  appears  that  an  excess  of  exports  sets  up  a  chain 
of  causation  tending  to  eliminate  that  excess:  said  excess  makes  a 
lower  rate  of  exchange ;  which  lowered  rate  makes  exporting  less, 
and  importing  more,  profitable;  which  decreases  exports  and  in- 
creases imports ;  which  finally  eliminates  the  excess  of  exports,  that 
is,  brings  exports  and  imports  to  an  equality.  An  analogous  course 
of  reasoning  would  show  that  an  excess  of  imports  must  tend  to 
disappear, — must  destroy  itself. 

Through  Money  Movements. — We  have  seen  that  an  excess 
of  either  exports  or  imports  is  self -destructive  or  self -corrective, 
through  its  influence  on  the  rate  of  exchange.  Such  an  excess  is 
self -corrective  also  through  its  influence  on  the  movements  of 
money*  If  a  country  is  exporting  more  than  it  imports,  the  ex- 


3  See  problems  u  and  12,  page  187. 

4  This  topic  is  more  fully  discussed  in  Chapter  XXXIV. 


2I4  PRINCIPLES  OF  ECONOMICS  [XVI 

change  dealers  of  that  country  will  presently  find  themselves  creditors, 
by  a  considerable  balance,  of  the  exchange  dealers  of  other  countries. 
Such  a  state  of  things  may  be  allowed  to  continue  for  a  few 
weeks  through  temporary  loans  to  their  correspondents  in  the  debtor 
countries.  But,  in  general,  such  balances  are  not  permitted  for 
any  considerable  period  in  international  trade;  and,  in  consequence, 
the  continuance  of  an  export  excess  soon  leads  to  a  movement  of 
money  toward  the  exporting  country  to  make  good  the  balance 
owing  that  country.  Such  a  movement,  however,  presently  causes 
the  reserves  of  the  banks  to  become  excessive,  makes  borrowing 
easy,  inflates  business  and  buying  in  general,  with  the  result  that 
prices  in  general  rise.  An  exactly  opposite  course  of  causation  in 
the  importing  countries  results  in  a  general  lowering  of  prices.  But 
the  raising  of  prices  in  the  exporting  country  and  the  lowering  of 
prices  in  the  importing  countries  make  the  former  an  undesirable 
market  to  buy  in,  and  the  latter  a  desirable  one.  In  consequence, 
the  exports  of  the  country  having  an  excess  of  exports  tend  to 
decline  while  its  imports  from  other  countries  tend  to  expand.  Thus, 
again,  an  excess  of  exports  is  self -corrective.  Exports  and  imports 
tend  to  become  equal  automatically. 

Let  us  now  embody  the  result  of  this  long  discussion  in  a  formal 
principle  as  follows: 

Principle — The  Principle  of  Reciprocity.5 

Exchange  between  communities,  as  between  individuals, 
is  necessarily  reciprocal;  and,  speaking  broadly,  the  total  of 
goods  (not  including  money)  sold  by  any  community  to  all 
other  communities  must  in  the  long  run  equal  the  total  of 
goods  (not  including  money)  bought  by  that  community 
from  all  others,  save  that  there  will  usually  tend  to  be  a 


"The  Principle  of  Reciprocity  here  laid  down  should  not  be  confused 
with  the  policy  of  reciprocity  much  advocated  and  occasionally  practiced 
in  this  country.  The  latter,  as  indicated,  is  a  policy  in  the  conduct  of  a 
nation's  commercial  relations,  not  a  natural  law  governing  phenomena. 
Further,  as  a  policy  reciprocity  has  its  chief  theoretic  basis  in  alleged  natural 
laws  which  are  quite  inconsistent  with  the  Principle  of  Reciprocity.  Most 
advocates  of  the  policy  of  reciprocity  are  more  or  less  pronounced  dis- 
believers in  the  Principle  of  Reciprocity. 


XVI]  PRINCIPLE  OF  RECIPROCITY  215 

slight  excess  of  goods  exported  from  communities  not  pro- 
ducing standard  money  metal  and  a  more  or  less  consider- 
able excess  of  goods  imported  into  a  country  producing 
standard  money  metal — it  being  assumed  that  the  distribution 
of  population  among  different  communities  remains  substan- 
tially unchanged. 

ILLUSTRATIVE  PROBLEMS 

1.  "Another  important  reason  for  keeping  our  fleets  as  far  as  pos- 
sible in  our  own  ports  is  that  under  this  policy  the  money  they  spend  for 
ordinary  supplies  goes  to  our  own  people." 

Explain  what  the  writer  probably  meant  and  criticize  it. 

2.  "To  the  same  extent  that  the  home  market  is  wrested  from  for- 
eigners and  given  to  protected  home  producers,  the  foreign  market  is 
wrested  from  unprotected  home  producers." 

Explain  and  defend  the  statement. 

3.  "When  I  came  to  Marblehead  they  had  their  houses  built  by 
country  workmen,  and  their  clothes  made  out  of  town,  and  supplied  them- 
selves with  beef  and  pork  from  Boston,  which  drained  the  town  of  its 
money." — Barnard's  Autobiography. 

Criticize  the  part  in  italics. 

4.  From  a  supposititious  editorial  of  a  Benton  Harbor  newspaper: 
"The  annual  influx  of  students  and  other  outsiders  into  the  fruit  belt 
to  engage  in  fruit  picking  and  packing  is  an  abuse  which   should  be 
stopped  at  once.     These  people  consume  very  little,  saving  their  money 
to  take  back  to  Ann  Arbor,  Chicago,  and  the  other  places  from  which 
they  came.     Thus,  while  making  large  sums  off  us,  they  give  little  or 
nothing  to  the  support  of  our  industries."     Criticize. 

5.  "One  reason  for  our  almost  constant  excess  of  exports  is  that  we 
are  enterprising  and  so  always  opening  up  new  markets." 

Objector:     "Opening  up  new  markets  might  increase  our  exports  but 
could  not  increase  our  excess  of  exports  unless  somebody  cheated  us." 
Defend  the  second  statement. 

6.  Remarks  of  a  leading  Congressman  when  it  was  announced  that 
the   Canal  Commission   would  purchase   supplies  wherever  they   could 
be  secured  most  cheaply :     "The  President  should  be  able  to  see  the  de- 
sirability of  purchasing  the  supplies  in  this  country  alone,  because  thus 


2i6  PRINCIPLES  OF  ECONOMICS  [XVI 

employment  would  be  given  to  American  capital  and  labor  instead  of 
foreign."     Explain  fallacy. 

7.  "The  chief  reason  for  our  excess  of  exports  is  to  be  found  in  the 
fact  that  the  things  which  we  sell  are  more  necessary  to  our  neighbors 
than  the  things  which  they  sell  are  to  us."     Criticize. 

8.  "The  true  way  to  quicken  foreign  demand  (for  British  goods)  was 
to  open  the  ports  to  that  foreign  supply  with  which  they  paid  us  for 
what  they  bought  from  us." — Morley's  Gladstone,  Volume  i,  page  267. 

Show  that  the  above  is  sound  doctrine. 

9.  "If  we  buy  rails  from  England,  we  get  the  rails  of  course,  but 
they  get  our  money;  while,  if  we  buy  the  rails  at  home,  we  have  the  rails 
and  the  money,  too." 

(a)  Is  there  any  reason  to  expect  that  our  buying  rails  in  England 
would  carry  off  our  regular  stock  of  money  ?     Explain. 

(b)  Substitute  "cotton"  for  "money"  throughout  the  above  quotation, 
and  show  the  fallaciousness -of  the  doctrine. 

10.  "The  trade  of  the  United  States  shows  an  excess  of  exports, 
because  it  is  a  large  resourceful  country  which  has  to  supply  other  coun- 
tries with  raw  materials."     Criticize. 

11.  "I  have  always  believed  that  free  trade  would  secure  the  greatest 
general  prosperity,  provided  that  all  countries  would  practice  it.     But,  if 
neighboring  countries  are  bound  to  maintain  protection,  it  is  only  fair  to 
ourselves  to  do  the  same." 

(a)  What  is  the  real  economic  evil  of  having  our  neighbors  shut 
out  our  goods? 

(b)  Would  we  better  matters  by  shutting  out  theirs? 

12.  A  Detroit  physician  who  has  a  son  in  the  University  at  Ann  Ar- 
bor requires  the  latter  to  buy  his  clothes  and  other  supplies  just  as  far 
as  possible  in  Detroit,  on  the  ground  that,  since  his  income  is  earned  in 
that  city,  it  ought  to  be  spent  there. 

(a)  Has  the  father  placed  himself  under  obligations  to  the  people 
of  Detroit  by  earning  an  income  from  them? 

(b)  Supposing  the  distribution  of  population  unchanged,  would  De- 
troit as  a  whole  get  any  more  employment  on  the  one  plan  than  on  the 
other  ? 

13.  A  Western  newspaper,  anxious  to  hinder  the  people  of  the  com- 
munity from  buying  outside,  represents  a  silver  dollar  as  appealing  to  a 


XVI]  PRINCIPLE  OF  RECIPROCITY  217 

home  dentist  about  to  send  it  to  the  Montgomery  Ward  Company  of 
Chicago,  in  the  following  strain : 

"Now,  look  here,  Doc.  If  you'll  only  let  me  stay  in  this  town  I'll 
circulate  around  and  do  you  lots  of  good.  You  buy  a  big  beef  steak  with 
me,  and  the  butcher  will  buy  groceries,  and  the  grocer  will  buy  dry  goods, 
and  the  dry  goods  merchant  will  pay  his  doctor  bill  with  me,  and  the 
doctor  will  spend  me  with  a  farmer  for  oats  to  feed  his  buggy'  horse,  and 
the  farmer  will  buy  fresh  beef  from  the  butcher,  and  the  butcher  will 
come  around  to  you  and  get  his  tooth  mended.  In  the  long  run,  you  see, 
I  will  be  more  useful  to  you  here  at  home  than  if  you  send  me  away 
forever." 

(a)  Clear  up  once  more  the  fundamental  errors  in  all  talk  of  this 
kind. 

(b)  Show  that,  even  if  we  admit  the  principle  implied  in  the  quota- 
tion (that  only  the  money  spent  at  home  can  complete  the  circuit  so  as  to 
get  back  to  the  original  spender),  only  a  very  small  portion  of  the  dollar 
could  -get  back  to  the  dentist. 

14.  English  people  own  much  capital  which  is  earning  interest  or 
dividends  in  other  countries.     What  effect  does  this  fact  tend  to  have  on 
England's  exports  or  imports? 

15.  "If  it  were  possible  for  one  county  to  provide  by  law  or  other- 
wise that  no  dollar  which  came  into  it  could  be  sent  out,  within  two  years 
the  county  would  be  so  much  richer  than  its  neighbors  that  they  would 
begin  to  wonder,  etc.'' — Western  newspaper. 

(a)  What  do  you  suppose  are  his  reasons   for  expecting  such  a 
policy  to  produce  the  great  prosperity  predicted? 

(b)  Show  that  his  great  expectations  are  unreasonable. 

(c)  Show  that  the  policy  in  question  would  be  likely  to  make  the 
county  poorer  rather  than  richer. 

1 6.  "You  admit  that  it  would  increase  the  productive  power  of  a 
given  county  to  have  a  man  with  one  hundred  thousand  dollars  move  in, 
bringing  his  money  with  him.     How,  then,  can  you  deny  that  the  county 
would  grow  richer  if  it  could  and  should  for  three  or  four  years  stop  all 
money  which  came  in  from  going  out?" 

Show  that  we  are  guilty  of  no  inconsistency  in  admitting  the  one 
contention  and  denying  the  other. 

17.  The  following  was  taken  from  a  country  newspaper  in  1908: 
"It  appears  to  this  paper  that  all  this  severe  criticism  ...  of  Mrs.  How- 
ard Gould's  requiring  $70,000  a  year  to  pay  her  expenses  is  quite  un- 


218  PRINCIPLES  OF  ECONOMICS  [XVI 

called  for.  What's  the  difference,  anyway?  If  she  and  her  folks  have 
the  'dough,'  let  them  spend  it  as  fast  as  they  like.  That's  better  than 
hoarding  it.  When  the  money  is  spent  it  goes  to  some  one  and  gets  into 
circulation.  We  people  whom  circumstances  compel  to  live  on  30  cents 
a  day  would  be  glad  to  see  all  the  old  millionaires  spending  each  $70,000 
a  year  on  himself,  or  ten  times  that  amount  if  he  wants  to.  The  money 
isn't  lost." 

(a)  State  clearly  what  advantage  the  writer  of  the  above  probably 
imagined  that  the  public  derive  from  the  extravagance  of  Mrs.  Gould 
and  other  rich  people. 

(b)  Explain  the  fallacy  in  the  doctrine. 

(c)  Show  that  the  last  sentence  of  the  quotation  is  of  no  significance 
in  the  matter. 

18.  "The  so-called  Principle  of  Reciprocity  is  all  rubbish.    It  is  child's 
play  to  show  that  we  can  sell  to  other  countries  even  if  we  do  not  buy 
from  those  countries'.    No  British  buyer  of  American  goods  asks  the 
question  whether  America  buys  British  goods.     His  only  question  is: 
'Does  this  article  in  character  and  price  suit  me?'     If  so,  he  buys  it. 
Further,  it  is  a  matter  of  common  knowledge  that  a  country  will  often 
buy  a  great  deal  from  some  other  country,  even  though  it  sells  little  or 
nothing  to  that  other  country.     Thus  Germany  has  no  better  customer 
than  England,  whose  goods  she  keeps  out  by  tariff.     So  we  buy  largely 
from  Brazil,  though  we  sell  her  very  little." 

(a)  State  the  Principle  of  Reciprocity. 

(b)  Show  that  the  arguments  against  this  principle  contained  in  the 
above  quotation  have  no  bearing  on  the  case. 

19.  "Our  neglect  of  the  South  American  trade  is  simply  scandalous. 
We  buy  a  large  amount  from  Brazil  every  year  but  sell  her  almost  noth- 
ing, leaving  her  markets  to  be  gobbled  up  by  England  and  other  European 
countries.     We  ought  to  subsidize  a  great  merchant  marine  running  to 
South  America,  and  drive  Europe  out  of  a  market  which  is  naturally 
ours." 

Show  that  a  very  plausible  argument  can  be  made  for  the  contention 
that  we  should  be  cutting  off  our  own  noses  if  we  were  to  drive  Europe 
out  of  the  markets  of  South  America. 

20.  "We  are  going  to  get  from  Germany  an  indemnity  of  forty  or 
fifty  billion  dollars;  but  we  are  not  going  to  let  her  utilize  this   fact 
to  build  up  her  industries  again  by  exporting  billions  of  dollars  worth  of 
goods  to  other  countries.     We   shall  take  our  indemnity   in  gold,   not 


XVI]  PRINCIPLE  OF  RECIPROCITY  219 

goods."     This  was  the  sort  of  talk  much  heard  in  the  Allied  countries, 
particularly  France,  during  the  winter  of  1918-1919. 

Show  that,  even  if  the  Allies  were  to  insist  on  being  paid  in  gold,  this 
would  necessitate  letting  Germany  export  billions  of  dollars  worth  of  her 
products,  it  being  remembered  that  Germany  has  less  than  $300,000,000  in 
gold  and  is  not  a  producer  of  that  metal. 


CHAPTER  XVII 

THE  LAW  OF  COMPARATIVE  COSTS 

We  come  now  to  a  fundamental  principle  of  trade  which  is 
somewhat  more  difficult  than  the  two  we  have  already  considered, 
and  yet  is  so  fundamental  as  to  call  for  treatment  in  this  connection. 
It  is  commonly  known  as  the  Law  of  Comparative  Costs.  This 
principle  may  be  looked  on  as  a  formal  answer  to  the  question: 
What  condition  must  be  fulfilled  to  make  it  worth  our  while  to 
cooperate  with  our  neighbors,  individual  or  national,  by  engaging 
in  trade  with  them?  Not  a  few  economists  would  very  likely  be 
disposed  to  affirm  that  there  is  really  no  necessity  of  answering  the 
question  in  any  other  than  the  common-sense  way.  It  is  worth  our 
while  to  trade  with  other  communities  when  and  only  when  their 
prices  make  it  profitable  to  do  so.  "We  can  go  deeper,"  he  might 
say,  "but  we  do  not  need  to.  There  is  no  better  index  to  the  fulfil- 
ment of  the  deeper  conditions  necessary  to  make  exchange-coopera- 
tion profitable  than  that  given  by  comparative  prices." 

How  the  Question  Arises. — This  solution  of  our  problem, 
however,  meets  serious  difficulties.  A  great  many  people  are  con- 
vinced on  personal  grounds  that  it  is  not  a  good  thing  to  have  trade 
go  just  where  it  naturally  would  in  view  of  price  conditions;  they 
usually  want  to  shut  out  some  goods  which,  if  we  had  regard  only 
for  prices,  we  should  naturally  buy  from  other  people.  They  find 
no  difficulty,  either,  in  adducing  excellent  reasons,  of  a  political  and 
social  sort,  why  we  should  do  this.  But,  in  order  to  bolster  up 
their  cause  they  usually  bring  forward  arguments  which  they  be- 
lieve to  be  based  on  fundamental  economic  principles.  They  try 
to  seek  out  some  reason  lying  behind  the  surface  fact  of  a  favorable 
price,  and  this  reason  usually  concerns  our  ability  to  produce  for 
ourselves  the  thing  we  buy  as  well  as,  or  better  than,  the  country 


XVII]  LAW  OF  COMPARATIVE  COSTS  221 

from  which  we  buy  it.  If  we  can  produce  it  more  easily  than  the 
other  people,  we  have  a  sure  case  for  the  wisdom  of  producing 
it  ourselves.  If  we  can  produce  it  just  as  easily  as  the  other  people, 
the  same  conclusion  is  almost  as  certain.  Even  if  we  cannot  produce 
it  as  easily  but  can  only  just  produce  it,  many  people  are  disposed 
to  declare  that  we  ought  not  to  buy  it  from  others.  But  these  ideas 
are  in  part  at  least  erroneous,  and  so  the  economist  is  forced  to  make 
a  deeper  analysis  than  would  otherwise  be  necessary. 

Simplest  Case. — One  condition  under  which  trade  between 
two  countries  would  surely  be  profitable  is  that  each  country  should 
be  able  to  produce  the  commodity  it  sells  at  a  cost  which  is  abso- 
lutely smaller  than  its  cost  in  the  other  country,  meaning  by  cost, 
labor,  waiting,  and  other  primary  factors.  Thus,  let  us  suppose 
that  in  country  A  broadcloth*  is  produced  at  a  cost  of  only  3  days' 
labor  (letting  labor  represent  all  real  costs),  while  in  country  B 
it  costs  4  days' ;  and  that,  on  the  other  hand,  iron  costs  in  country 
B  only  1 6  days'  labor,  while  it  costs  18  days'  in  country  A.  That 
is,  broadcloth  is  produced  at  smaller  absolute  cost  in  A ;  iron  at 
smaller  absolute  cost  in  B.  Under  these  conditions,  we  will  surely 
believe  that  A  will  profit  by  using  broadcloth  to  buy  iron  from 
B ;  and  the  latter  will  profit  by  using  iron  to  buy  broadcloth  from 
A.  But  why  will  this  be  true?  What  is  the  real  economic  ex- 
planation of  the  matter  ?  For  this  we  need  to  go  a  little  deeper. 

If  we  look  at  the  figures  of  our  example  from  another  standpoint, 
we  note  that  the  people  of  A  spend  only  one-sixth  as  much  labor 
on  the  cloth  as  on  the  iron ;  while  the  people  of  B  spent  one-fourth 
as  much  on  the  former  as  on  the  latter.  But  it  is  a  commonplace 
of  business,  though  not  yet  treated  in  our  discussion,  that  the  com- 
parative prices  of  things  must  show  at  least  a  rough  correspondence 
with  their  costs  of  production.  It  follows  that,  in  country  A,  a 
yard  of  cloth  will  be  worth  only  one-sixth  as  much  as  a  ton  of  iron; 
while,  in  country  B  it  will  be  worth  one-fourth  as  much.  Or,  if  we 
look  at  the  matter  primarily  from  the  standpoint  of  iron,  a  ton  of 
this  will  be  worth,  in  A,  six  times  as  much  as  a  yard  of  cloth ;  while, 
in  B,  it  will  be  worth  only  four  times  as  much.  In  short,  if  each 
commodity  be  measured  in  terms  of  the  other,  broadcloth  is  much 


222  PRINCIPLES  OF  ECONOMICS  [XVII 

cheaper  in  A,  iron  much  cheaper  in  B.  It  follows  that  B  would 
profit  by  buying  the  cloth  it  wants  in  A,  provided  payment  could 
be  made  in  iron ;  while  A  would  profit  by  buying  the  iron  it  wants 
in  B,  provided  payment  could  be  made  in  cloth.  But  manifestly 
these  two  desirable  possibilities  exactly  fit  each  other.  B  wants 
to  use  its  iron  to  buy  A's  cloth ;  and  A  wants  to  use  its  cloth  to  buy 
B's  iron.  Evidently,  then,  trade  between  the  countries  would  be 
profitable  under  the  condition  assumed,  namely,  that  each  can  pro- 
duce the  commodity  it  exports  more  cheaply  than  the  other  can 
produce  that  commodity. 

Difference  in  Absolute  Cost  Unnecessary. — It  seems  probable 
that  the  most  important  cases  of  profitable  trade  between  different 
countries  are  included  under  the  case  just  considered, — each  coun- 
try is  superior  in  respect  to  the  commodity  it  exports  and  inferior 
in  respect  to  the  commodity  it  imports.  But,  as  was  long  ago 
brought  out,  this  statement  does  not  cover  all  cases,  and  is  in  fact 
misleading.  If  we  stopped  here  the  reader  might  very  naturally 
conclude  that  trade  would  pay  only  when  the  condition  just  ex- 
plained was  present,  and  that  we  ought  never  to  buy  a  thing  from 
other  countries  if  we  could  produce  that  thing  as,  cheaply  as  those 
other  countries. 

Case  of  the  Individual. — The  unsoundness  of  the  doctrine 
as  applied  to  an  individual  is  at  once  evident.  Here,  for  example, 
is  a  lawyer  who  very  likely  can  mow  his  lawn,  cultivate  his  garden, 
and  take  care  of  his  furnace  much  better  than  the  person  or  persons 
whom  he  hires  to  do  these  things.  Nevertheless,  he  devotes  himself 
to  the  practice  of  his  profession,  and  buys  the  services  named  from 
other  people.  And  he  of  course  acts  wisely  in  doing  so,  for  it  is 
plain  that  he  gains  most  by  using  his  whole  time  and  energy  on  the 
kind  of  work  for  which  he  is  best  fitted.  He  is  not  interested  in 
the  fitness  or  unfitness  of  his  neighbor  as  compared  with  himself, 
but  rather  in  the  degree  in  which  his  own  fitness  in  one  line  is  greater 
than  his  fitness  in  another  line.  So  long  as  he  can  find  a  market 
for  his  possible  output,  he  would  better  devote  his  time  entirely  to 
doing  the  kind  of  work  for  which  he  is  preeminently  fitted,  and  get 


XVIII  LAW  OF  COMPARATIVE  COSTS  223 

his  supplies  of  other  things  from  his  neighbors,  even  though  he 
can  make  those  other  things  better  than  his  neighbors. 

What  the  lawyer  cares  about  is  not  whether  he  can  produce  the 
thing  he  buys  less  cheaply  than  the  man  from  whom  he  buys  it, 
but  whether  he  can  produce  that  thing  which  he  himself  sells  more 
cheaply  than  he  can  produce  the  thing  which  it  will  buy  for  him. 
In  other  words,  what  is  the  cheapest  way  for  him  to  get  shoes — 
to  produce  them  himself  or  to  produce  legal  services,  sell  these, 
and  use  the  proceeds  to  buy  shoes?  It  is  his  comparative  efficiency 
in  the  two  directions  which  determines  his  conduct.  Put  in  another 
way,  it  is  the  comparative  cost  to  himself  of  producing  the  two 
different  commodities  which  determines  whether  he  shall  produce 
a  given  one  or  buy  it.  He  naturally  chooses  to  produce  the  one 
which  has  the  lower  cost  to  himself. 

Case  of  a  Nation. — Now,  a  community  or  nation  is  in  this 
respect  no  different  from  an  individual.  England,  let  us  say,  pro- 
duces principally  cloth,  getting  most  other  goods  through  exchange 
with  outside  communities.  England  is  really  better  fitted  to  produce 
some  of  the  things  she  buys  than  are  the  people  who  actually  do 
produce  them,  and  she  is,  moreover,  perfectly  well  aware  of  the 
fact. 

But,  like  our  lawyer,  England,  though  superior  to  other  coun- 
tries in  many  respects,  confines  her  productive  efforts  to  the 
industry  or  industries  wherein  she  is  most  superior.  The  condition 
which  makes  her  desire  to  trade  is  not  a  certain  ratio  between  her 
own  efficiency  and  that  of  other  countries,  but  rather  a  certain  ratio 
between  her  own  efficiency  in  one  industry — put  in  terms  of  cost — 
and  her  own  efficiency — put  in  terms  of  cost — in  other  industries. 

But  this  alone  would  not  make  possible  trade  between  England 
and  other  countries.  These  countries  must  also  have  a  motive  for 
wanting  to  trade.  How  is  this  possible  ?  England,  we  have  assumed, 
is  superior  all  along  the  line ;  hence  China  must  be  assumed  to  be 
inferior  all  along  the  line.  She  is  inferior  in  cloth,  inferior  in  iron, 
inferior  in  potatoes.  But  while  England,  being  universally  superior, 
has  a  motive  for  trading,  we  must  now  find  a  motive  for  China,  in 
spite  of  the  fact  that  she  is  universally  inferior. 


224  PRINCIPLES  OF  ECONOMICS  [XVII 

Though  not  so  evident  on  the  surface,  this  problem  easily  clears 
itself  upon  a  little  reflection.  If  China  is  inferior  to  England  in 
respect  to  both  cloth  and  iron,  she  will  surely  find  an  advantage  in 
specializing  where  her  inferiority  is  less.  If  she  is  three-fourths  as 
efficient  in  producing  iron,  and  only  one-half  as  efficient  in  producing 
cloth,  it  will  pay  her  to  produce  iron  and  buy  cloth.  Here  again  the 
matter  which  the  country  is  interested  in  is,  not  the  cost  of  each 
commodity  at  home,  as  compared  with  the  cost  abroad,  but  the 
comparative  cost  at  home  of  the  two  commodities. 

Thus,  both  the  country  universally  superior  in  production,  and 
the  one  universally  inferior,  might  have  adequate  motive  for  resort- 
ing to  exchange.  Before  exchange  could  actually  take  place,  of 
course,  the  particular  exchange  that  is  desirable  for  one  country 
would  have  to  be  the  same  that  is  desirable  for  the  other.  The 
differences  in  comparative  efficiency  should  be  complemental  to  each 
other.  If  England  is  more  efficient  in  the  production  of  cloth  than 
in  the  production  of  iron,  while  China  is  more  efficient  in  the  produc- 
tion of  iron  than  in  that  of  cloth,  then  it  will  be  feasible  for  them 
to  effect  the  specialization  which  would  naturally  be  profitable  to 
them;  for  the  greater  superiority  of  the  one  just  fits  the  smaller 
inferiority  of  the  other.  By  using  its  cloth  to  buy  iron,  England 
takes  advantage  of  its  greater  superiority;  while,  by  using  iron  to 
buy  cloth,  China  takes  advantage  of  its  lesser  inferiority. 

The  principle  which  embodies  the  essential  points  brought  out 
above  has  long  been  known  as  the  Law  of  Comparative  Costs.  It 
may  be  formally  stated  as  follows : 

Principle — The  Law  of  Comparative  Cost. 

Broadly  speaking,  in  order  to  make  the  exchange  of  two 
commodities  between  two  countries  profitable  it  is  only 
necessary  that  the  comparative  cost  of  the  commodity  ex- 
ported by  either  of  the  two  countries  should  be  less  in  that 
country  than  in  the  importing  country. 

Specific  Proof. — The  general  argument  for  this  principle  has 
perhaps  been  developed  as  fully  as  is  necessary  or  desirable  in  the 
explanation  leading  up  to  its  statement.  However,  it  may  be  well 


XVII]  LAW  OF  COMPARATIVE  COSTS  225 

to  add  a  proof  analogous  to  that  just  used  in  the  case  where  each 
country  was  supposed  to  be  superior  in  respect  to  the  product  it 
exported.  Thus,  let  us  change  that  hypothesis  so  as  to  make  the 
cost  of  iron  in  A  30  days'  labor  and  that  of  broadcloth  in  the  same 
country  5  days',  leaving  costs  in  B  the  same  as  before:  16  days' 
and  4  days'.  On  this  hypothesis,  we  shall  have  the  same  com- 
parative values  of  iron  and  cloth  in  each  of  the  countries  as  under 
the  former  hypothesis.  That  is,  iron  will  be  worth  6  yards  of 
cloth  in  A,  and  only  4  yards  in  B ;  while  cloth  will  be  worth  % 
of  a  ton  of  iron  in  B  and  only  1/6  in  A.  It  will,  therefore,  pay 
the  people  of  A  to  use  their  cloth  to  buy  iron  in  B ;  and  will  pay  the 
people  of  B  to  use  their  iron  to  buy  cloth  in  A.  Thus  the  trade 
which  was  profitable  to  both  under  the  first  hypothesis  continues  to 
be  so,  though  A  is  inferior,  B  superior,  in  both  industries. 

Before  leaving  this  topic  one  further  comment  should  be  added. 
We  have  all  along  spoken  merely  of  the  reciprocal  trade  of  two 
countries.  As  a  matter  of  fact,  most  international  trade  is  not  of 
any  such  directly  reciprocal  character — it  is  triangular,  or  multi- 
angular.  England  sells  cloth  to  Brazil ;  Brazil  sells  beef  and  hides 
to  America;  America  sells  cotton  and  iron  to  England.  At  bottom, 
however,  although  a  complete  demonstration  of  the  fact  might 
prove  very  difficult,  the  cases  of  reciprocal  and  multiangular  trade 
are  substantially  the  same.  The  condition  which  makes  specialization 
and  exchange  profitable  is  a  difference  between  the  comparative  real 
costs  to  one  country  of  the  things  exchanged  and  their  comparative 
real  costs  to  other  countries. 

ILLUSTRATIVE  PROBLEMS 

i.  Country  A  can  produce  pig  iron  at  a  cost  of  10  days'  labor  per 
ton  and  broadcloth  at  a  cost  of  5  days'  labor  per  yard.  Country  B  can 
produce  the  iron  at  a  cost  of  14  days'  labor  and  the  cloth  at  a  cost  of  6 
days'  labor. 

(a)  What,  in  this  example,  are  the  comparative  costs  which  our 
principle  tells  us  must  be  unequal  to  make  exchange  pay? 

(b)  Prove  in  detail  that,  if  transportation  and  all  costs  other  than 
labor  be  ignored,  exchange  of  these  two  products  will  pay. 

(c)  Which  commodity  will  country  A  export? 


226  PRINCIPLES  OF  ECONOMICS  [XVII 

2.  Make  a  hypothetical  case  yourself  and  prove  with  it  that  ex- 
change will  not  pay  if  comparative  costs  are  equal. 

3.  "We  may  often  by  trading  with  foreigners,  obtain  their  commod- 
ities at  a  smaller  expense  of  labor  than  they  cost  the  foreigners  them- 
selves." 

(a)  Show  with  illustration  that  this  is  true. 

(b)  Show  how  such  a  trade  could  be  profitable  to  the  foreigner. 

(c)  What  do  you  suppose  is  the  ultimate  cause  which  explains  the 
fact  that  such  trade  can  be  profitable? 

4.  "We  know  that  England  can  make  ships  more  cheaply  than  we 
can,  and  so  we  should  let  her  do  the  ship  building  and  turn  our  capital 
to  such  things  as  we  can  do  better  than  she  can." 

Assuming  the  conclusion — that  we  should  turn  our  capital  to  other 
things — to  be  correct,  the  reason  given  for  it  is  not  entirely  satisfactory. 
Explain. 

5.  "It  seems  probable  that  Southern  California  would  be  very  foolish 
to  devote  itself  to  raising  wheat  even  if 'it  could  raise  twice  as  much 
wheat  per  acre  as  any  other  district  in  the  world."    Why? 


CHAPTER  XVIII 

SPECULATIVE  TRADING  AND  INSURANCE 

In  this  chapter  we  purpose  to  comment  briefly  on  two  forms  of 
economic  activity  a  knowledge  of  which  has  not  seemed  quite  essen- 
tial to  the  development  of  our  study,  but  which,  certainly,  we  ought 
not  to  ignore  altogether.  These  are  Speculative  Trading  and  In- 
surance. 

Risk-Bearing  a  Necessary  Function. — It  must  be  manifest 
by  this  time  that  risk,  the  risk  of  loss,  both  physical  and  economic, 
is  an  ever-present  element  in  economic  life.  There  is  constant 
danger  that  goods  shall  undergo  physical  destruction  or  deterioration, 
and  danger  that  the  value — the  economic  significance — of  goods  shall 
decline.  Now  these  risks,  being  ineradicable  elements  in  economic 
life,  individuals,  or  society  as  a  whole,  must  in  some  way  bear  them. 
As  has  already  been  brought  out  again  and  again,  a  large  number 
of  the  risks  incident  to  productive  activity  are  borne  by  the  central 
figure  in  production,  the  entrepreneur.  It  has  indeed  been  main- 
tained by  some  writers  that  not  only  the  entrepreneur's  greatest, 
but  his  only,  function  is  the  assumption  of  the  risk  of  production. 
The  position  on  this  point  taken  in  the  present  text  has  been  some- 
what less  extreme.  We  recognize  that  the  assumption  -of  the  re- 
sponsibility of  production  involves  some  other  burdens  as  well  as 
risk-taking,  including  some  very  general  types  of  labor.  Neverthe- 
less it  must  be  admitted  that  the  chief  part  of  the  entrepreneur's 
task  or  function  is  to  bear  risk. 

Types  of  Risk. — Again,  as  has  been  explained  in  other  con- 
nections, risks  are  chiefly  of  two  types:  (i)  those  which  regularly 
recur  and  so  are  calculable  and  (2)  those  of  irregular  nature  which 
cannot  be  reduced  to  any  law  of  recurrence.  The  entrepreneur's 

227 


228  PRINCIPLES  OF  ECONOMICS  [XVIII 

function  in  risk-bearing  is  especially  connected  with  the  second  type. 
But  he  is  not  the  only  one  who  contributes  to  the  bearing  of  this 
burden.  In  fact,  no  economic  person  can  be  completely  rid  of  it; 
and  one  person  especially,  the  man  who  engages  in  speculative  trad- 
ing, shares  in  it  very  largely.  Our  first  section,  therefore,  is  given 
to  an  account  of  speculation  or  speculative  trading. 


Speculative  Trading 

Nature  of  Speculation. — The  nature  of  speculation  can  best 
be  realized  by  contrasting  it  with  related  functions  and  operations. 
As  already  noted,  speculation  is  akin  to  the  function  of  the  entre- 
preneur in  that  it  assumes  non-calculable  risks.  It  differs,  however, 
in  that  it  frequently  divorces  this  assumption  of  risk  from  owner- 
ship; whereas  the  distinctive  mark  of  the  risk -bearing  of  the  entre- 
preneur is  that  he  assumes  that  burden  by  the  process  of  becoming 
the  owner  of  the  goods.  He  assembles  the  various  productive  ele- 
ments necessary  for  bringing  a  commodity  into  existence  and  accepts 
the  responsibility  from  first  to  last,  including  the  ownership  of  the 
products  when  completed.  The  speculator  in  the  narrow  sense  does 
not  necessarily  do  this;  in  fact,  a  very  characteristic  feature  of  his 
trading  is  the  cutting  apart  of  these  two  functions.  Thus  men  who 
purchase  wheat  in  large  amounts  and  store  it  for  sale  at  a  future 
time  commonly  turn  over  to  someone  else  the  burden  of  bearing 
the  risk  of  possible  loss  between  the  purchase  and  the  sale  of  such 
wheat  by  selling  against  it  other  wheat  for  future  delivery. 

Speculative  Trading  and  an  Ordinary  Business. — Again,  spec- 
ulative trading  is  distinguished  from  ordinary  or  so-called  legitimate 
business  in  that  it  expects  to  make  a  profit  out  of  changes  in  the 
prices  of  commodities  in  the  same  market;  whereas  ordinary  trade 
expects  to  get  its  profit  out  of  price  differences  in  different  markets. 
To  illustrate,  the  speculator  in  wheat  on  the  Chicago  market  buys 
wheat  today  expecting  to  sell  it  at  a  later  date  in  the  same  market 
when  the  price  shall  have  advanced.  He  very  likely  sells  to  another 
person  like  himself  who  deals  in  the  goods  for  the  same  purpose 


XVIII]  SPECULATIVE  TRADING  AND  INSURANCE  229 

of  making  a  profit  through  purchase  and  sale.  In  contrast  with  this 
we  have  ordinary  or  legitimate  trading  when  a  commission  house 
buys  wheat  from  someone  really  having  it  for  disposal  and  sells 
that  wheat,  not  to  some  other  dealer,  but  to  a  miller  who  wishes 
to  turn  it  into  flour.  That  is,  he  buys  in  the  wholesale  dealers' 
market  and  sells  in  the  millers'  market.  Between  the  prices  of  these 
two  markets,  there  is  a  recognized  and  admittedly  legitimate  differ- 
ence at  the  same  time.  This  .difference  is  the  source  of  the  profit 
to  the  dealer.  Another  way  of  characterizing  legitimate  or  ordinary 
trade  is  to  say  that  it  carries  the  goods  forward  one  stage  on  the 
way  from  the  original  producer  to  the  ultimate  consumer ;  whereas 
speculation  merely  tosses  it  back  and  forth  between  dealers  at  the 
same  stage, — the  wholesale  market  stage. 

It  ought,  perhaps,  to  be  added  to  the  above  account  of  this 
matter  that  some  admixture  of  speculative  trading  is  often  present 
in  ordinary  business  or  at  any  rate  may  be  so  present.  Ordinary 
dealers  of  speculative  temperament  will  every  now  and  then  load 
up  with  an  unusually  large  stock  of  some  commodity,  the  price  of 
which,  in  their  opinion,  is  likely  to  advance.  This  is  in  the  strictest 
sense  speculation,  not  what  is  commonly  called  legitimate  business. 

Speculation  and  Gambling. — We  have  distinguished  the  risk- 
bearing  of  the  speculator  from  that  of  the  entrepreneur  and  his  type 
of  dealing  from  that  of  the  ordinary  trader.  We  need  also  to  dis- 
tinguish speculation  from  gambling  with  which  it  is  often  identified. 
Gambling,  as  pointed  out  in  other  connections,  has,  from  the  eco- 
nomic standpoint,  this  distinguishing  mark :  it  involves  the  assump- 
tion of  a  needless  risk.  In  many  cases  the  risk  is  created  for  the 
occasion.  For  example,  the  gambler  throws  a  pair  of  dice  out  of 
a  box,  betting  on  which  side  will  turn  up.  On  the  other  hand, 
gambling  may  take  place  in  connection  with  chances  which  naturally 
exist,  for  example,  in  the  outcome  of  some  notable  series  of  events, 
an  election  or  a  war.  But  although  the  chance  is  here  of  natural 
origin,  the'  assumption  of  economic  risk  with  respect  to  that  chance 
is  not  of  natural  origin.  It  is  entirely  artificial.  It  is,  for  the 
moment,  uncertain  whether  Mr.  Cox  or  Mr.  Harding  will  be 
elected ;  the  uncertainty,  the  chance,  is  here  anyhow ;  but  I  am  not 


230  PRINCIPLES  OF  ECONOMICS  [XVIII 

driven  to  assume  any  economic  risk  in  connection  with  this  uncer- 
tainty. In  contrast  with  gambling,  speculative  trading  not  only 
involves  inevitable  uncertainty  and  chance,  it  also  involves  a  neces- 
sary economic  risk.  The  price  of  wheat  may  change  between  Septem- 
ber and  March:  In  fact  it  is  practically  certain  to  change.  No  man 
experienced  in  such  matters  will  anticipate  the  recurrence  of  pre- 
cisely the  same  price  six  months  from  date.  This  element  of  uncer- 
tainty or  chance  must  necessarily  entail  loss  to  someone.  If  it 
should  be  a  fall,  the  present  owner  will  lose;  if  it  should  be  a  rise 
the  persons  who  will  need  to  purchase  the  wheat  will  inevitably 
lose.  Speculation  is,  therefore,  not  gambling,  but,  within  limits,  the 
performance  of  a  necessary  economic  function. 

Characteristics  of  Exchanges  (Bourses) . — The  most  thor- 
oughgoing forms  of  speculative  trading  are  carried  on  in  special 
markets,  of  which  the  wheat,  cotton,  and  stock  exchanges — called 
bourses  on  the  continent  of  Europe — are  the  most  conspicuous  ex- 
amples. These  markets  have  as  their  most  notable  characteristics 
the  following: 

(1)  Trading  in  common.     The  majority  of  the  dealers  taking 
part  are  brought  together  in  one  place  at  the  same  time;  buyers 
competing  with  buyers  and  sellers  with  sellers. 

(2)  Another    characteristic    is    open-trading.      There    is    no 
privacy  as  respects  the  dealings.     The  amounts,  prices,  and  so  on 
are  at  once  announced  and  recorded  by  the  proper  officers. 

(3)  The  trading  is  through  official  dealers,  brokers,  as  they 
are  ordinarily  called. 

(4)  The  dealings  are  usually  on  a  very  large  scale. 

(5)  The  major  part  of  the  trading  is  speculative.     There  is, 
of  course,  some  selling  by  persons  who  have  produced  the  goods 
and  brought  them  to  the  market  for  disposal,  and  so  there  are  some 
persons  who  have  come  to  the  market  to  buy  for  actual  use  outside. 
This  last  is  illustrated  by  men  in  the  milling  district  who  purchase 
their  wheat  supply  in  large  amounts  at  these  exchanges'.     But  the 
major  part  of  the  dealings,  probably  more  than  90  per  cent  of  them, 
are  carried  on  by  men  who  are  engaged  in  speculation  as  such.     By 
this  is  meant  that  they  are  not,  if  buyers,  intending  to  make  any 


XVIII]  SPECULATIVE  TRADING  AND  INSURANCE  231 

use  of  the  product,  while,  if  sellers,  they  are  not  producers  or 
ordinary  middlemen  who  are  bringing  the  goods  to  market.  What 
they  are  doing  is  attempting  to  make  a  gain,  if  buyers,  by  getting 
at  one  price  and  presently  selling  at  a  higher  one.  If  sellers,  they 
have  already  purchased  at  a  low  price  and  are  now  reaping  the 
gain  resulting  from  the  advance.  Or  they  may  be  selling  for  future 
delivery,  agreeing  to  deliver  the  goods  at  some  future  date,  con- 
fident that  they  will  be  able  to  make  the  necessary  purchases  at  the 
time  of  delivery  at  a  lower  price  than  that  agreed  upon. 

(6)  This  last  statement  suggests  another  characteristic  of 
produce  speculative  trading,  namely,  dealing  in  futures.  By  this  is 
meant  nothing  more  than  contracting  to  deliver  or  to  accept  at  some 
future  time  a  quantity  of  goods  at  a  price  now  agreed  upon.  Such 
contracts  for  future  delivery  are  of  course  present  in  all  lines  of 
business.  We  order  a  suit  of  clothes,  we  order  wood,  or  coal,  to 
be  delivered  at  some  future  time;  the  contractor  orders  structural 
steel  and  lumber  in  advance  of  the  time  when  he  will  need  it. 
But  the  future  trading  of  the  speculative  market  differs  from  these 
cases  in  that  it  is  not  something  occasional,  growing  out  of  a  special 
need  of  the  consumer  or  producer,  but  is  systematically  and  con- 
stantly entered  into  for  the  sake  of  the  possible  profits  to  be  obtained, 
or  for  some  other  ends  which  will  be  explained  in  a  moment. 

Technique  of  Speculative  Market. — It  may  contribute  to  our 
understanding  of  this  matter  to  note  some  of  the  technique  of  the 
speculative  market.  As  stated  above,  the  dealers  directly  concerned 
in  the  processes  of  buying  and  selling  are  known  as  brokers,  and  they 
are  constantly  taking  and  fulfilling  orders.  (The  brokers,  however, 
are  usually  supposed  to  refrain  from  personal  dealings,  and  to  buy 
or  sell  only  on  the  account  of  other  persons.)  The  real  dealer  in 
the  transaction  is  commonly  some  outside  party,  perhaps  located  in  a 
remote  city. 

Some  of  the  dealers  on  the  market  habitually  deal  with  the  ex- 
pectation of  making  a  profit  from  a  rise  in  prices ;  that  is,  they  buy 
today  with  the  intention  of  selling  later  when  prices  have  advanced. 
They  are  known  as  bull  speculators,  or  simply  bulls.  In  contrast, 
some  dealers  habitually  anticipate  and  deal  with  an  eye  to  a  fall  in 


232  PRINCIPLES  OF  ECONOMICS  [XVIII 

prices.  Such  dealers  sell  for  future  delivery, — "go  short,"  is  the 
expression  frequently  used.  They  agree  to  deliver  certain  goods 
which  they  do  not  at  the  present  moment  own.  Dealers  of  this  type 
are  known  as  bear  speculators,  or  simply  bears. 

A  special  feature  of  short  selling  on  the  stock  market  'is  the 
borrowing  of  stock.  On  most  stock  exchanges,  in  this  country  at 
least,  the  rules  require  the  delivery  of  the  goods  sold  within  twenty- 
four  hours.  By  hypothesis,  however,  the  dealer  is  not  in  possession 
of  those  goods.  It,  therefore,  becomes  necessary  that  he  should 
borrow  from  those  persons  who  do  own  the  required  stock.  As  a 
rule,  he  has  no  difficulty  doing  this  because  the  owners  are  glad 
to  be  released  of  the  burden  of  interest-bearing  which  ownership 
involves.  Circumstances  may  arise,  however,  under  which  the  de- 
mand for  stock  to  deliver  on  short  sales  is  so  great  that  it  is  prac- 
tically impossible  to  find  enough  stock  to  meet  the  emergency.  The 
result  in  this  case  is  a  crisis  to  the  bears  in  which  great  sums  are 
lost. 

Marginal  Trading. — Another  bit  of  technique  of  importance 
is  the  so-called  margins  and  marginal  trading.  Everywhere  in  busi- 
ness life  there  is  dealing  on  borrowed  capital.  Probably  the  majority 
of  traders  in  all  highly-developed  countries  depend  on  the  capital 
of  other  people  for  a  considerable  part  of  that  which  is  needed  in 
their  business.  They  borrow  outright  from  capitalists  on  personal 
notes,  or  they  meet  any  particular  bill  from  wholesalers  by  raising 
a  special  sum  for  that  emergency.  Essentially  the  case  is  no  differ- 
ent in  margin  trading  on  exchange.  That  is,  the  purchaser  wishes 
to  buy  five  hundred  shares  of  Pennsylvania  stock  and  has  not  more 
than  a  tenth  of  the  capital  necessary  to  do  so.  He  naturally  desires 
to  borrow  the  rest  of  the  money  needed  from  someone  else.  This 
is  particularly  easy  in  stock  transactions  or  speculative  transactions 
generally  for  the  reason  that  the  security  is  readily  realized  upon  and 
very  efficient  machinery  for  facilitating  the  process  has  been  built 
up.  The  man  who  wishes  to  make  such  a  purchase,  therefore,  de- 
posits with  his  broker  that  portion  of  the  purchase  price  which  he 
himself  expects  to  pay,  authorizing  the  broker  to  borrow  the  rest 
of  the  money  needed.  The  sum  which  he  deposits  with  his  broker 


XVIII]  SPECULATIVE  TRADING  AND  INSURANCE  233 

to  cover  his  part  of  the  money  advanced  is  called  a  margin  and 
trading  of  this  type  is  known  as  marginal  trading. 

As  explained  above,  this  borrowing  is  in  essence  no  different  from 
borrowing  in  other  lines  of  business.  In  practice,  however,  it  is  a 
more  dangerous  type.  This  is  partly,  of  course,  due  to  the  more 
dangerous  character  of  the  business.  In  addition,  the  facilities  given 
tempt  dealers  to  go  into  the  speculation  on  a  much  larger  scale 
than  their  own  capital  will  warrant.  It  is  always  provided  that  the 
broker  can  dispose  of  the  stock  he  holds  as  security  for  the  loan 
whenever  his  client  fails  to  maintain  his  margin,  and  this  of  .course 
makes  that  broker  perfectly  willing  to  lend  to  the  limit  of  reason- 
ableness. 

The  last  remark  suggests  two  or  three  other  technical  phrases 
employed  in  speculative  trading.  To  keep  up  one's  margin  is  to  send 
in  more  money  if  at  any  time  the  change  in  the  value  of  the  stock 
makes  the  previous  margin  inadequate.  So  when  the  broker  realizes 
on  the  loan  he  has  made  by  selling  the  stock  of  his  client  he  is  said 
to  close  him  out. 

Functions  of  Speculative  Trading. — We  have  seen  that 
speculative  trading  is  one  of  the  several  methods  by  which  the  risk 
burden  incident  to  all  economic  life  is  borne.1  And  this  risk-bearing 
naturally  would  be  thought  of  as  the  primary  function  of  specu- 
lative trading.  A  second,  perhaps  equally  important,  function  is 
maintaining  conditions  for  the  determination  of  the  right  price.  Let 
us  now  consider  more  carefully  these  two  functions  in  detail. 

The  Risk-Bearing  Function  Illustrated. — The  way  in  which 
speculation  carries  out  its  primary  function  of  assuming  the  burden 
of  risk-bearing  is  best  illustrated  in  the  wheat  business.  As  already 
remarked,  it  is  inevitable  that  there  should  be  losses  unmerited  and 
gains  unmerited  from  changes  in  the  price  of  any  commodity  from 
one  part  of  the  year  to  another.  Further,  there  will  be  persons 
in  the  community  who  are  not  fit  to  assume  this  burden,  although 
so  situated  that  they  will  be  forced  to  do  so  unless  some  device  is 


1  From    the    standpoint    of    society   at   large    it    is   a   cheap    and    efficient 
method  of  bearing  these  risks. 


234  PRINCIPLES  OF  ECONOMICS  [XVIII 

created  whereby  the  burden  can  be  unloaded.  Thus,  millers  must 
have  wheat,  and  they  must  buy  it  considerably  in  advance  of  the 
time  when  they  can  market  the  flour  made  from  that  wheat.  But 
in  the  interim  the  price  of  wheat  may  fall  greatly  and  as  a  result 
the  price  of  flour  will  fall.  The  millers  will  therefore  be  liable 
to  a  serious  loss  growing  out  of  this  possible  change  in  prices. 

It  might  be  argued  that  this  is  only  one  of  the  inevitable  burdens 
of  their  particular  function  in  industrial  life  and  so  they  ought  to 
bear  it  without  murmur.  A  very  characteristic  feature,  however, 
of  modern  industrial  life  is  extreme'  specialization, — the  working  out 
of  devices  whereby  the  different  burdens  of  productive  activity  can 
be  separated  and  assigned  to  different  agents.  Now  the  miller  has 
as  his  primary  function  the  turning  of  wheat  into  flour.  It  is  his 
performance  of  this  service  that  entitles  him  to  a  living.  He  has  no 
ambition  to  speculate  in  wheat  as  such,  to  make  a  living  by  dealing 
in  this  commodity  so  subject  to  changing  prices.  He  would  there- 
fore be  glad  to  utilize  some  device  whereby  this  part  of  the  burden 
would  be  thrown  onto  someone  else. 

The  wheat  exchange  fills  his  need  exactly.  He  wishes  to  buy, 
let  us  say,  ten  thousand  bushels  of  wheat  to  be  turned  into  flour 
in  the  course  of  the  next  few  months.  Accordingly,  he  gives  an 
order  to  a  broker  on  the  Chicago  exchange  for  that  amount  of  cash 
wheat,  that  is,  of  wheat  to  be  delivered  at  once.  At  the  same  time 
he  orders  the  broker  to  sell  for  future  delivery  at  the  date  when  he 
expects  to  have  his  flour  ready  for  the  market,  ten  thousand  bushels 
of  wheat, — the  price  being  fixed  at  the  present  moment,  in  relation 
to  the  present  price  of  cash  wheat.  In  the  fall  of  the  year  this  will 
mean  a  higher  price  for  future  deliveries  because  of  the  cost  of 
storing,  insurance  and  interest  on  the  investment.  Now  when  the 
future  period  comes  he  will  get  for  the  ten  thousand  bushels  of 
wheat  the  price  agreed  upon  anyhow.  If,  in  order  to  meet  this 
sale  that  he  has  made,  he  has  to  pay  a  higher  price  than  was  antici- 
pated, he  loses  on  the  deal,  but  makes  a  corresponding  amount  from 
the  advance  of  his  flour.  On  the  other  hand,  if  at  that  time  he  is 
able  to  buy  in  the  wheat  for  delivery  at  a  lower  price,  he  gains  on 
this  future  deal,  but  loses  on  the  flour  which  has  fallen  because 
of  the  fall  of  wheat.  In  short,  the  net  resultant  of  the  whole  transac- 


XVIII1  SPECULATIVE  TRADING  AND  INSURANCE  235 

tion  is  that  he  neither  gains  nor  loses  by  changes  in  the  price  of 
wheat.  He  is  thus  limited  to  what  he  calls  legitimate  business,  the 
milling  business,  the  turning  of  wheat  into  flour.  Out  of  that  he 
makes  his  living  and  leaves  other  people  to  speculate  in  wheat.  It 
will  contribute  to  a  better  understanding  of  this  explanation  to 
follow  an  imaginary  transaction  in  detail. 

Let  us  suppose  that  our  milling  company  sets  out  to  supply  itself 
with  wheat  at  a  time  when  that  grain  is  quoted  for  immediate  delivery 
at  $i  and  for  future  delivery  at  $1.04.  Our  problem,  then,  is  to 
determine  by  experiment  what  the  result  will  be  when  the  trans- 
action is  quite  ended  for  each  of  the  different  possibilities  as  to  the 
price  actually  prevailing  when  the  future  deal  is  consummated. 
Manifestly,  these  possibilities  will  be  covered  by  three  hypotheses:  a 
price  at  the  future  date  exactly  equal  to  the  expected  one,  $1.04;  any 
price  higher  than  the  expected  one,  say,  $1.10;  and  any  price  lower 
than  $1.04,  say,  $.90.  The  three  tables  following  give  the  results 
for  these  three  hypotheses  in  their  order.  Each  time  the  net  result 
is  neither  gain  nor  loss. 

TABLE  I 

CASH  WHEAT  FUTURE 

Original   cost    $10,000     Cost    $10,400 

Storage,  insurance,  etc 400 


Total   cost    $10,400 

Value  10,400     Selling  value  10,400 


Gain  or  loss $00,000     Gain  or  loss $00,000 

TABLE  2 

CASH  WHEAT  FUTURE 

Total   cost    $10,400      Cost    $11,000 

Value   11,000      Selling  value  10,400 


Gain   $     600     Loss    $     600 

TABLE  3 

CASH  WHEAT  FUTURE 

Total  cost $10,400     Cost    $  9,000 

Value    9,000      Selling  value  10,400 


Loss    $  1,400      Gain    $  1,400 


236  PRINCIPLES  OF  ECONOMICS  [XVIII 

ILLUSTRATIVE  PROBLEMS 

1.  A  Liverpool  miller  buys  through  a  Dutch  commission  house  30,000 
bushels  of  wheat,  paying  93  cents  a  bushel,  and  at  the  same  time  sells 
30,000  bushels  for  May  delivery,  the  price  being  95/4  cents. 

(a)  Assuming  that  2j4  cents  covers  the  cost    (storage,  insurance, 
and  interest)  of  carrying  the  wheat  from  the  date  of  purchase  till  May, 
show  that  the  miller  will  lose  nothing  on  the  wheat  even  if  by  May  the 
price  should  fall  to  70  cents. 

(b)  Would  he  gain  if  the  price  should  rise  to  $1.10?     Prove. 

(c)  What  did  the  word  "carrying"  in  the  second  sentence  of  the 
problem  mean? 

2.  "One  of  the  most  important  functions  of  speculation  is  to  hasten 
the  working  of  the  processes  whereby  production  is  adjusted  to  fluctuat- 
ing demand."     Explain  how  speculation  does  this. 

Speculation  and  Right  Price.— We  have  explained  the  pri- 
mary, central  function  of  speculation,  the  assumption  of  the  risk 
burden  of  a  particular  type  of  economic  activity.  The  second  of  the 
two  functions  mentioned  above — working  out  a  proper  price — must 
be  commented  upon  briefly.  As  already  so  often  remarked,  price  is 
pre-eminently  regulative  mechanism  of  the  present  economic  order. 
And  we  mean  by  right  price  that  price  which  will  regulate  eco- 
nomic activity  in  accord  with  the  demands  of  the  situation  as  a 
whole.  Now  it  is  manifestly  of  the  utmost  importance  that  the  right 
price  should  prevail.  If  there  is  likely  to  be  a  diminution  of  the 
acreage  put  into  wheat  because  of  the  outbreak  of  the  great  war  it 
is  highly  important  that  something  should  happen  to  induce  countries 
unaffected  by  the  war  to  increase  the  amount  of  wheat  which  they 
raise.  But  of  course  nothing  can  contribute  so  effectively  to  this 
result  as  an  advance  in  the  price  of  wheat,  and  that  an  early  advance. 
But  again  nothing  can  so  surely  bring  about  this  much-needed  result 
as  the  efficient  working  of  a  great  speculative  market. 

In  these  great  markets  we  have  a  large  number  of  competing 
dealers  on  both  sides,  men  of  exceptional  capacity,  keenness,  and 
knowledge,  furnished  with  every  facility  for  getting  information 
regarding  the  probabilities  of  demand  and  production  in  all  parts  of 
the  world.  In  consequence,  if  there  is  good  reason  to  believe  that 


XVIII]  SPECULATIVE  TRADING  AND  INSURANCE  237 

prices  should  naturally  change,  that  the  conditions  of  demand  and 
supply  will  create  in  the  near  future  a  much  higher  price,  that  higher 
price  is  likely  to  be  brought  into  existence  much  sooner,  much  more 
completely  than  without  such  a  market.  This  was  exactly  what 
happened  in  the  summer  of  1914  at  the  outbreak  of  the  Great  War. 
It  happened  again  in  the  summer  of  1916  when  the  failure  of  the 
new  crop  was  in  prospect,  and  it  was  just  what  ought  to  have  hap- 
pened, although  it  was  constantly  misinterpreted  and  lamented  by 
men  in  power  who  were  too  little  informed  with  respect  to  the 
working  of  economic  laws.  The  sharp  advance  in  the  price  of 
wheat  meant  that  the  farmers  who  could  produce  winter  wheat, 
which  was  to  be  sown  in  the  fall  of  the  year,  would  promptly  im- 
prove their  opportunity,  would  proceed  to  increase  the  acreage  as 
rapidly  as  possible.  A  rise  in  price  which  had  waited  for  months 
till  after  the  consumer  began  to  feel  it  clearly,  would  have  been 
too  late  to  bring  the  needed  result.  An  advance  in  price  brought 
about  early;  before  any  but  the  trained  and  well-informed  speculator 
could  anticipate  the  whole  result,  was  just  the  thing  which  the 
situation  called  for. 

II 

Insurance:   Its  Nature  and  Functions 

Nature  of  Insurance. — The  essential  nature  of  insurance  con- 
sists in  the  pooling,  putting  into  one  mass,  of  a  large  number  of  risks. 
In  other  words,  the  many  persons  interested  act,  for  this  particular 
purpose,  as  if  they  constituted  just  one  person.  Thus,  if  the  indi- 
vidual owners  of  a  thousand  houses  desire  to  insure  themselves 
against  loss  by  fire,  they  proceed  to  act  in  the  matter  as  if  all  the 
houses  were  owned  by  them  as  a  group.  If  any  house  burns  down, 
the  group  replaces  it  by  contributions  raised  from  all  members  of  the 
group.  Otherwise  the  houses  are  treated  as  if  owned  by  individuals, 
but  in  this  respect  they  are  treated  as  if  owned  by  the  group. 

Now  the  function  of  this  economic  activity,  this  industry,  if  you 
please,  is  readily  seen  by  considering  the  advantage  derived  from 
the  practice  indicated.  If,  in  the  illustration,  we  suppose  each  house 
to  be  worth  $2,000,  then  without  such  pooling  as  insurance  pro- 


238  PRINCIPLES  OF  ECONOMICS  [XVIII 

vides,  the  burning  of  one  of  these  houses  would  mean  a  total  loss 
to  the  owner,  a  loss  of  $2,000.  On  the  other  hand,  if  pooling  takes 
place,  the  result  of  the  fire  is  that  each  owner  loses  $2.  The  ad- 
vantage of  such  a  procedure,  supposing  only  a  few  houses  burn 
down,  is  manifest.  Each  owner  is,  indeed,  obliged  to  lose  something. 
But  this  amount  is  quite  small  and  in  exchange  for  it  he  is  saved  from 
the  risk  of  losing  his  whole  $2,000.  In  other  words,  the  individual's 
advantage  from  insurance  may  be  summarized  as  the  substitution  of 
a  series  of  small,  though  certain,  losses  for  the  chance  of  a  great 
loss.2  But  this  means  that  insurance  makes  less  burdensome  to 
the  individual  the  risk  incident  to  economic  ownership.  Accord- 
ingly, the  function  of  insurance  is  to  secure  the  easier  bearing  of 
risk. 

All  Insurance  Mutual. — The  preceding  account  seemed  to 
deal  only  with  what  is  called  mutual  insurance, — insurance  in  which 
the  parties  insured  are  responsible  for  the  procedure,  manage  the 
whole  business.  But  most  insurance,  as  we  know,  is  not  technically 
of  this  character.  Instead,  it  is  undertaken  by  a  great  corporation 
which  "sells"  insurance,  as  the  agent  would  say,  as  other  corpora- 
tions sell  gas  and  electricity.  Has  our  account  covered  this,  case? 
Surely,  yes.  In  essence,  all  insurance  is  mutual.  The  fund  from 
which  the  company  makes  good  the  losses  to  householders  whose 
houses  burn  in  reality  comes  not  from  the  company,  but  from  all  the 
householders.  If  these  were  not  making  regular  payments  adequate  to 
cover  the  total  losses  of  the  group,  the  company  would  have  nothing 
to  pay.  The  only  difference  between  this  case  and  that  of  strict 
mutual  insurance  is  one  of  management,  procedure.  In  the  latter, 
the  insured  householders  organize  to  manage  the  business  themselves, 
accepting  all  the  responsibilities  and  burdens.  In  the  former  case, 
speculative  insurance  it  is  often  called,  a  corporate  entrepreneur 
undertakes  to  carry  out  the  plan,  assume  all  the  responsibilities,  and 
do  the  necessary  work.  The  essence  of  the  matter,  as  before,  is  the 


"This  surely  is  a  social  as  well  as  individual  advantage.  The  strain  upon 
industry,  the  loss  of  efficiency  due  to  the  falling  of  a  great  loss  upon  a 
single  individual  is  much  greater  than  that  of  a  trifling  loss  experienced  by 
many  individuals. 


XVIII]  SPECULATIVE  TRADING  AND  INSURANCE  239 

pooling  of  risks,  the  acting  as  one  owner  in  respect  to  the  burden 
of  ownership. 

It  should  be  said  also  that  while  the  foregoing  account  of  in- 
surance dealt  only  with  loss  from  fire,  an  exactly  similar  analysis 
would  fit  the  case  for  insurance  ^against  any  type  of  economic  loss, 
for  example,  cyclone,  shipwreck,  collision,  etc. 

What  Risks  Insurable. — The  last  remark  suggests  that  we 
need  some  comment  on  the  question :  Under  what  conditions  is  the 
insurance  principle,  the  principle  of  pooling  risks  in  order  to  diminish 
their  economic  burden,  applicable?  The  answer  is  this:  the  insur- 
ance principle  can  be  used  wherever  risks  are  fairly  calculable.  If 
we  can  prove  statistically  that,  when  any  large  body  of  losses  are 
taken  together,  the  per  cent  of  loss  is  only  moderately  high,  and 
fairly  regular,  insurance  is  feasible.  Doubtless  this  is  a  somewhat 
vague  rule;  but  it  has  answered  in  the  building  up  of  great  busi- 
nesses. With  the  improvements  in  statistical  art,  and  the  enlarge- 
ment of  the  pools,  it  has  been  possible  to  extend  the  operation  of 
this  industry  more  and  more  widely ;  and  doubtless  we  have  not  yet 
seen  the  end  of  its  development. 

Life  and  Endowment  Insurance. — Thus  far  we  have  had  in 
mind  only  insurance  against  direct  loss,  for  example,  fire  insurance, 
tornado  insurance,  burglar  insurance.  But  the  student  is  aware 
that  very  important  forms  of  insurance  are  so-called  life  and  endow- 
ment insurance.  Are  these  to  be  explained  in  the  same  way?  In 
the  main,  yes.  In  one  respect,  however,  they  obviously  differ  from 
the  cases  already  considered.  The  payments  made  to  the  insured 
or  his  family  are  not  intended  to  cover  losses  incurred.  They  rather 
represent  savings,  accumulations  of  capital,  which  he  has  made  or 
is  treated  as  having  made.  The  payments  which  the  insured  makes 
to  the  officers  of  the  association  or  company — premiums — consist, 
in  the  cases  already  considered,  of  two  parts,  (i)  a  real  insurance 
premium,  his  share  of  the  losses  incurred,  and  (2)  his  share  of 
the  costs  of  carrying  on  the  business.  In  life  or  endowment  in- 
surance, the  major  part  of  the  payment  is  different  from  either  of 
these.  It  is  savings  deposit,  money  accumulated  and  placed  in  the 


240  PRINCIPLES  OF  ECONOMICS  [XVIII 

hands  of  the  company  as  if  it  were  a  savings  hank.  The  insurance 
element  in  his  payments  is  so  much  as  is  needed  to  cover  the  risk 
that  he  will  not  live  and  save  long  enough  to  accumulate  the  full 
amount  he  has  set  out  to  save  and  for  which  he  is  insured.  The 
insuring  company  or  association  is  concerned  with  knowing  how 
many  payments  he  is  likely  to  make, — which  is  usually  the  same 
as  saying  how  many  years  he  will  live.  Their  statistics  concern  the 
average  longevity  of  men  in  his  class ;  the  statistics  of  the  com- 
panies concerned  in  fire  insurance  concern  the  probable  number  of 
houses  of  certain  types  which  will  burn  in  a  given  period. 

Within  the  memory  of  people  still  living,  not  a  few  persons 
of  intelligence  and  standing  were  wont  to  look  on  insurance,  par- 
ticularly life  insurance,  as  a  form  of  gambling.3  What  has  been 
said  ought  to  convince  us  of  the  unsoundness  of  this  opinion.  In- 
surance manifestly  performs  a  very  real  service.  It  does  easily 
and  cheaply  something  which  must  be  done.  Risk  cannot  be 
eliminated  from  economic  relations.  It  must  be  borne.  Our  only 
freedom  of  choice  concerns  the  method  of  bearing  it.  Insurance 
is  surely  the  best  one  yet  devised. 

ILLUSTRATIVE  PROBLEMS 

1.  Suppose  1,000  owners  of  1,000  buildings  worth  each  $7,000  wish 
to  insure  themselves  against  fire.     If  the  risk  for  the  class  of  buildings 
involved  is  such  that  7  out  of  1,000  burn  down  each  year,  what  annual 
payment  from  each  owner  would  be  necessary  to  insure  all  against  total 
loss, — expenses  of  management,  interest,  etc.,  being  ignored? 

2.  Suppose  1,000  persons  propose  each  to  save  for  his  family  before 
his  death,  $2,000.     All  are  twenty-five  years  of  age.     Knowing  that  any- 
one is  liable  to  die  before  he  has  had  time  to  save  so  much,  they  combine 
to  insure  one  another  that  $2,000  shall  be  ready  for  the  family  even  if 
death  comes  before  that  sum  has  been  regularly  accumulated.     Assum- 
ing that  the  organization  is  continuous,  new  members  joining  as  old  ones 


*  In  one  notable  case,  the  spirit  and  even  the  practice  of  gambling  has 
not  been  kept  out  of  connection  with  legitimate  insurance.  This  is  the  great 
Marine  Insurance  Association  known  as  Lloyds  of  London.  Here  men  are 
able  to  put  up  bets  on  any  conceivable  event  without  any  admixture  of 
necessity  or  social  gain  to  make  it  a  legitimate  economic  operation. 


XVIII]  SPECULATIVE  TRADING  AND  INSURANCE  241 

pass  away,  and,  assuming  the  average  death  rate  to  be  18  in  1,000,  what 
annual  payment  would  each  one  need  to  make, — expenses  of  management, 
interest,  etc.,  being  ignored? 

3.  Suppose  that  a  certain  corporation  owns  500  buildings  worth  each 
$100,000;  that  to  insure  in  an  ordinary  company  would  cost  the  cor- 
poration $250  a  year  on  each  building;  and  that  the  corporation  is  con- 
vinced that  by  an  annual  expenditure  of  $10,000  the  fire  loss  can  be  re- 
duced to  an  average  of  one  building  every  three  years.  Under  these 
conditions,  would  it  pay  the  corporation  to  insure  with  some  company  ? 
Prove. 


CHAPTER  XIX 

VALUE  AND  PRICE:    PRELIMINARY 

With  the  present  chapter  we  begin  the  study  of  value  and 
price,  a  topic  which,  as  indicated  in  an  earlier  connection,  consti- 
tutes the  very  heart  of  economic  science.  This  topic  will  continue 
to  form  the  subject  of  our  study  during  the  seven  chapters  follow- 
ing— in  fact,  it  will  receive  much  of  our  attention  throughout  the 
remainder  of  the  text.  In  this  chapter  we  shall  confine  ourselves 
to  some  preliminary  topics. 

Economic  Value. — The  fundamental  idea  which  in  this  text 
is  usually  attached  to  the  phrase  "Economic  Value,"  and  not  in- 
frequently to  the  word  "value"  standing  alone,  was  brought  out 
in  our  opening  chapter.  Economic  value  is  the  property  of  having 
definitely  mensurable  and  effective  worth,  the  property  of  making 
the  thing  to  which  it  attaches  conduct-determining  in  a  definitely 
mensurable  fashion.  As  thus  conceived,  the  word  does  not  carry 
any  suggestion  of  power  in  exchange..  From  our  present  point  of 
view,  the  latter  property  is  only  a  manifestation  of  economic  value 
in  the  more  fundamental  sense.  Economic  value,  as  thus  under- 
stood, would  be  present  in  the  economic  life  of  a  Crusoe,  though 
exchange,  and  so  exchange  value,  would  be  completely  shut  out  by 
the  circumstances  of  the  case.  For  the  same  reason,  this  would 
also  be  the  conception  of  economic  value  appropriate  to  a  communistic 
system  of  economic  organization. 

In  our  study  of  the  present  economic  order,  we  need  this  deeper 
conception  of  economic  value  to  help  us  both  in  getting  a  more 
adequate  comprehension  of  exchange  value  and  in  supplying  our- 
selves with  a  standard  for  judging  whether  or  not  the  present 
system  of  price  determination  is  working  properly.  For  this  second 
purpose,  however,  we  need  the  broader  concept  of  value  as  modified 

242 


XIX]  VALUE  AND  PRICE:  PRELIMINARY  243 

by  the  adjective  "real."  By  real  value  we  mean  the  value  attaching 
to  things  in  view  of  all  the  fundamental  facts  of  the  situation, — 
momentary,  accidental  elements  being  ignored.  It  is  the  value  which 
most  persons  would  say  ought  to  be  embodied  in  the  actual  prices 
of  the  market,  though  all  would  agree  that  this  result  is  seldom  or 
never  precisely  attained.  It  may  also  be  conceived  as  the  value  which 
the  government  of  a  communistic  order  would  endeavor  to  make 
their  guide  in  regulating  the  economic  action  of  the  community,  in 
trying  to  insure  that  the  productive  resources  at  their  disposal  were 
utilized  to  the  very  best  advantage. 

Valuations. — When  any  person  comes  to  realize  that  his  wel- 
fare is  dependent  upon  the  possession  of  particular  units  of  any 
good,  that  is,  when  he  realizes  that  each  unit  of  such  a  good  has 
effective  importance  for  him,  he  inevitably  comes  to  take  a  certain 
psychological  attitude  toward  it,  he  prizes  it  or  sets  store  by  it.1 
Further  he  estimates  the  degree  to  which  he  prizes  it,  the  degree  to 
which  it  seems  to  him  important,  essential  to  his  welfare,  in  terms 
of  some  measuring  unit,  usually  money.  This  process  we  call 
evaluation ;  and  the  estimates  themselves,  we  call  valuations.  These 
valuations,  obviously,  must  play  a  very  important  part  in  the  processes 
by  which  value  or  price  is  determined,  if  the  desires  of  the  persons 
who  are  to  consume  goods  are  to  be  taken  into  account.  As  we 
shall  see  in  a  later  chapter,  these  valuations  vary  with  the  quantity 
of  the  commodity  in  question  'which  the  person  interested  con- 
ceives himself  to  have  in  possession;  and  these  different  valuations, 
corresponding  to  differences  in  quantity,  together  make  up  what  we 
call  his  valuation  schedule,  which  in  turn  helps  to  determine  what 
we  call  his  demand  schedule. 

Price. — This  concept  of  valuation  brings  us  to  another  of 
very  great  importance  in  this  connection,  price.  The  valuations  of 
the  buyer's  schedule,  looked  at  as  sums  of  money  which  he  is  in 
effect  offering  to  pay  for  the  goods  in  question,  are  prices.  That 


1  The   property    or   state   of    being    thus    prized    is    sometimes    designated 
subjective  value. 


244  PRINCIPLES  OF  ECONOMICS  [XIX 

is,  a  price  in  this  connection  is  a  sum  of  money  which  is  being 
offered  for  a  unit  of  the  goods  under  consideration.  This  concept, 
price,  also  appears  when  we  approach  the  matter  from  the  stand- 
point of  those  who  wish  to  sell  the  commodity  in  question.  That 
is,  price  includes  the  idea  of  a  sum  of  money  for  which  sellers 
actually  offer  to  exchange  a  unit  of  some  given  commodity.  Again, 
we  apply  the  designation,  price,  to  the  sum  of  money  which  actually 
passes  from  buyer  to  seller  in  a  specific  transaction.  In  all  these 
three  cases,  there  is  reference  to  an  actual  transaction,  though  in  the 
first  two  cases,  the  transaction  is  merely  contemplated,  not  consum- 
mated; and,  in  most  good  usage,  this  reference  to  an  actual  transac- 
tion, contemplated  or  consummated,  is  an  essential  element  in  the  con- 
cept. For  example,  if,  in  speaking  of  a  particular  object,  say  a 
residence,  we  have  in  mind  nothing  more  than  what  informed  per- 
sons would  consider  its  real  worth,  a  reasonable  price  for  it,  we  say 
that  its  value,  not  its  price,  is  so  and  so.  We  speak  of  the  price 
of  that  residence  only  when  we  are  thinking  of  a  figure  at  which 
the  owner  has  offered  to  sell  it,  or  at  which  someone  has  offered 
to  buy  it,  or  at  which  it  has  actually  changed  hands. 

A  further  mark  of  price  is  that  it  is  concerned  with  a  single 
conventional  unit  of  the  commodity,  not  with  an  aggregate.  We 
speak  of  the  price  of  a  bushel  of  wheat;  but  not  of  the  price  of 
the  wheat  crop  of  the  United  States.  For  this  latter  purpose,  the 
term  value  is  used,  and  means  simply  the  price  multiplied  by  the 
total  number  of  units. 

ILLUSTRATIVE  PROBLEM 

It  is  not  uncommon  to  find  in  economic  textbooks  the  statement  that 
price  is  exchange  value  expressed  in  terms  of  money.  Do  you  suppose 
that  the  author  of  such  a  text  would  say  that  the  annual  gold  product  of 
the  United  States  has  a  price  of  ninety  million  dollars?  How  would  he 
probably  express  the  fact? 

Exchange  Value. — A  fourth  concept  which  seems  essential 
to  an  adequate  theory  of  value  is  exchange  value.  By  this  we  mean 
the  property  belonging  to  economic  goods  of  being  able  to  command 
in  exchange  other  economic  goods.  Though,  as  already  remarked, 


XIX]  VALUE  AND  PRICE:  PRELIMINARY  245 

this  is  really  no  more  than  a  special  manifestation  of  economic 
value  in  the  fundamental  sense,  under  the  present  order  it  is  char- 
acteristic of  practically  all  economic  goods,  and,  therefore,  is  most 
usually  in  our  minds  when  we  employ  the  word  value  alone.  Thus, 
in  interpreting  the  antithesis  brought  out  under  the  last  heading  be- 
tween value  and  price,  we  ought  probably  to  understand  by  value, 
not  the  fundamental  concept  explained  under  the  phrase  "economic 
value,"  but  rather  exchange  value.  For  example,  when  the  statisti- 
cian says  that  the  value  of  the  corn  crop  of  1900  was  seven  hundred 
and  fifty  million  dollars,  we  understand  this  to  mean  that  this  sum 
was  what  the  crop  of  two  billion  bushels  would  presumably  have 
brought  on  the  market,  a  particular  price  being  assumed  for  the  pur- 
pose of  making  this  computation. 

The  Scope  of  Value  Theory. — The  chief  general  task  of  value 
theory  is  to  ascertain  the  causes  and  principles  which  regulate  value 
and  price,  though  it  is  usual  also  to  give  considerable  attention  to 
the  origin  of  value  and  price.  In  this  text,  comment  on  the  latter 
topic  is  chiefly  incidental.  The  problem  of  value  and  price  de- 
termination, taken  by  itself,  is  of  very  broad  scope,  including  much 
more  than  we  can  hope  to  cover.  In  fact,  one  might  say  with  pro- 
priety that  a  really  complete  theory  of  value  would  consist  of  a 
group  of  theories,  each  devoted  to  the  topic  developed  in  one  special 
way.  For  example,  it  would  be  very  natural  to  undertake  to  work 
out  (i)  a  theory  of  real  values  from  the  standpoint  of  the  individual, 
(2)  a  theory  of  real  values  from  the  standpoint  of  society,  (3)  an 
abstract  theory  of  competitive  prices — prices  under  an  order  of  free 
private  initiative  like  the  present  one,  (4)  a  concrete  theory  of 
competitive  prices  under  the  present  order — prices  as  they  actually 
work  out  under  the  present  order,  (5)  a  theory  of  values  under 
communism,  (6)  a  theory  of  prices  under  a  socialistic  order,  and 
so  on. 

As  a  matter  of  fact,  traces  of  all  the  types  of  theory  specifically 
named  above  are  present  in  most  economic  treatises,  though  often 
probably  without  clear  recognition  by  the  author  himself.  The 
particular  one  of  these  which  avowedly  occupies  the  principal  place 
in  economic  texts  is  the  third,  the  abstract  theory  of  competitive 


246  PRINCIPLES  OF  ECONOMICS  [XIX 

prices,  though  this  is  usually  preceded  or  accompanied  by  discus- 
sions belonging  under  the  first  theory.  Incidentally,  the  second, 
the  theory  of  real  social  values,  receives  some  attention,  particularly 
when  the  author  is  trying  to  pass  judgment  on  the  satisfactoriness 
of  the  present  economic  order.  The  fourth  point  of  view  is  im- 
plicit in  the  comments  usually  made  with  respect  to  discrepancies 
between  the  working  of  things  as  represented  in  the  abstract  theory 
of  competitive  prices  and  their  actual  working.  In  like  manner, 
notions  belonging  to  a  value  theory  for  communism  or  socialism 
not  infrequently  appear  in  the  course  of  a  discussion  of  our  present 
topic.  As  noted  above,  however,  the  major  part  of  the  conven- 
tional treatment  of  our  present  topic  belongs  to  the  third  type  of 
value  theory,  that  is,  the  abstract  theory  of  competitive  prices;  and 
this  statement  will  be  true  of  the  present  text. 

The  Abstract  Theory  of  Competitive  Prices. — By  an  abstract 
theory  of  competitive  prices,  we  mean  a  theory  which  confines  its 
attention  to  a  few  of  the  major  causes  and  conditions  at  work  in 
a  competitive  society  like  ours,  and,  on  the  basis  of  these,  works  out 
a  body  of  principles  with  respect  to  the  determination  of  prices  in 
such  an  order  when  perfectly  realizing  the  conditions  proposed.  It 
should  be  added  that  this  type  of  value  theory  is  not  only  abstract, 
in  that  it  limits  our  attention  to  a  portion  of  the  causes  and  con- 
ditions present;  it  is  also  hypothetical,  in  that  it  assumes  a  greater 
degree  of  uniformity  in  the  forces  and  conditions  which  it  retains 
than  actually  exists  in  the  real  world. 

As  already  indicated,  the  treatment  of  value  in  the  present  text 
follows  this  conventional  line.  That  is,  the  main  discussion  will 
be  concerned  with  the  abstract  theory  of  competitive  prices,  and 
that  even  more  completely  than  is  usual ;  but  matters  belonging  to 
other  bodies  of  value  theory  will  appear  at  various  points. 

Definition  of  Market. — A  concept  quite  necessary  in  the  study 
of  value  or  price  is  represented  by  the  word  "market."  By  this 
we  mean  a  total  constituted  by  a  group  of  freely  and  directly  com- 
peting sellers  or  buyers  over  against  a  coordinate  group,  of  freely 
and  directly  competing  buyers  or  sellers.  Here  some  careful  ex- 


XIX]  VALUE  AND  PRICE:  PRELIMINARY 


247 


planation  is  needed.  The  phrase  "directly  competing"  in  the  above 
definition  is  intended  to  bring  out  the  idea  that  the  sellers  or  buyers 
of  a  given  commodity,  say,  coffee,  are  not  all  members  of  the  same 
market.  Thus,  the  importers  of  coffee,  the  jobbers  distributing  it 
to  retailers,  the  retailers  selling  it  to  consumers,  though  all  sellers 
of  coffee,  do  not  as  sellers  belong  to  the  same  coffee  market.  The 
first  belong  to  the  coffee  market  constituted  by  themselves  as  sellers 
and  the  jobbers  as  buyers, — the  importers'  market.  In  turn,  the  job- 
bers, looked  at  as  sellers,  belong  to  the  market  constituted  by  them- 
selves as  sellers  and  the  retailers  as  buyers, — the  wholesale  market. 
In  turn,  the  retailers,  as  sellers,  belong  to  the  market  made  up  by 
themselves  as  sellers  and  consumers  as  buyers, — the  retail  market. 

The  above  statement  must  not  of  course  be  understood  as  deny- 
ing that  the  sellers  in  the  importers'  market  have  an  influence  on 
the  price  of  coffee  in  the  wholesale  market,  or  that  the  sellers  in  the 
wholesale  market  have  an  influence  on  the  price  in  the  retail  market. 
On  the  contrary,  in  each  case,  such  influence  is  very  great  or  even 
decisive.  This  influence,  however,  is  only  indirect,  being  affected 
through  the  buyers  in  the  particular  market  under  consideration, 
who  in  turn  become  sellers  in  the  next  market.  Thus,  jobbers, 
though  not  members  of  the  retail  market,  influence  the  price  in  the 
market  by  helping  to  determine  the  price  at  which  retailers  are 
willing  to  sell.  This  way  of  looking  at  the  matter  explains  the 
phrase  in  our  above  definition  "directly  competing."  That  is,  the 
sellers  or  buyers  who  are  directly  competing  in  any  particular  market 
form  a  part  of  the  group  of  sellers  or  the  group  of  buyers  who 
truly  belong  to  that  market. 

The  preceding  explanation  with  respect  to  the  distinction  be- 
tween the  buyers  or  sellers  of  a  given  commodity  in  one  market 
and  the  buyers  or  sellers  of  that  commodity  in  another  market, 
shows  the  necessity  for  the  phrase  "coordinate  group"  which  ap- 
pears in  our  definition.  The  only  proper  course,  surely,  is  to 
combine  the  selling  group  of  the  importers'  market  with  the  buy- 
ing group  of  that  same 'market,  not  with  the  buying  group  of  the 
wholesale  market  nor  with  that  of  the  retail  market. 

It  should  be  noted  that  the  above  definition  of  market  omits 
any  reference  to  a  specific  place.  Though  a  market  usually  has  a 


24g  PRINCIPLES  OF  ECONOMICS  [XIX 

location,  the  really  essential  element  in  it  is  rather  a  threefold  set 
of  relations:  (i)  those  among  the  sellers,  (2)  those  among  the 
buyers,  and  (3)  those  between  the  two  groups  over  against  each 
other.  If  men  in  Chicago,  Detroit,  and  Duluth  are  freely  competing 
with  each  other  in  selling  wheat  to  the  same  general  group  of  buyers, 
they  belong  to  the  same  market  though  located  in  widely  separated 
cities.  On  the  other  hand,  if  two  persons  living  in  the  same  city 
and  both  selling  coffee  are  after  all  dealing  with  different  groups  of 
buyers,  they  do  not  belong  to  the  same  market.  Thus,  Mr,  For- 
syth,  a  resident  of  Poughkeepsie,  who  sells  to  jobbers  coffee  which 
he  imports  from  Brazil,  does  not  belong  to  the  same  market  as 
Mr.  Sanders,  another  resident  of  Poughkeepsie,  who  retails  coffee 
to  consumers  in  that  city. 

Competition. — In  an  earlier  chapter  we  made  some  reference 
to  competition,  defining  it  in  a  general  way  as  the  striving  for  the 
same  prizes,  the  pursuit  of  the  same  opportunities,  by  similar  units. 
It  is  not  necessary  to  repeat  any  large  part  of  those  earlier  com- 
ments; but,  in  view  of  the  fact  that  competition  comes  to  a  focus, 
so  to  speak,  in  the  field  with  which  we  are  now  concerned, — the 
determining  of  prices — it  seems  desirable  to  introduce  one  or  two 
comments  here. 

Competition  is  between  Units  of  Same  Group. — First,  let  us 
once  more  remind  ourselves  of  one  of  the  most  fundamental  features 
of  true  competition,  namely,  that,  as  in  all  cases  of  true  rivalry, 
the  competing  persons  must  function  in  the  same  general  way. 
Buyers  are  competing  with  other  buyers,  not  with  sellers ;  sellers 
are  competing  with  other  sellers,  not  with  buyers.  The  applicants 
for  a  job  with  the  Michigan  Central  Railway  Company  are  com- 
peting with  one  another,  not  with  the  railway  company.  So  the 
railway  company  is  competing,  not  with  the  applicants,  but  with 
other  employers  of  such  types  of  labor.  Doubtless  the  successful 
applicant  and  the  company  will  each  try '  to  gain  some  economic 
advantage  at  the  expense  of  the  other, — the  applicant  to  get  higher, 
the  company  to  pay  lower,  wages  than  the  market  justifies.  But 
this  antagonistic  striving  is  not  competition.  It  belongs  rather  to 


XIX]  VALUE  AND  PRICE:  PRELIMINARY 


249 


another  line  of  action,  namely,  bargaining,  the  process  through  which 
seller  and  buyer  come  to  an  agreement. 

Involves  Action  of  Opposite  Group. — A  second  comment  with 
respect  to  competition  which  it  seems  desirable  to  make  is  that,  in  a 
sense,  full  competition  on  the  part  of  the  persons  belonging  to  either 
group — buyers  or  sellers — really  involves  some  action  on  the  part 
of  the  members  of  the  other  group.  Strictly  speaking,  the  competi- 
tion of  sellers  is  only  partial,  not  truly  complete,  unless  every 
seller  really  gets  his  bid  or  offer  before  every  buyer.  So  the  com- 
petition of  buyers  is  not  complete,  unless  every  buyer  gets  his  bid 
or  offer  before  every  seller.  Since  the  utmost  effort  on  the  part  of 
sellers  would  never  suffice  to  get  their  offers  before  all  buyers,  unless 
the  latter  did  something  to  help  in  the  process,  we  may  say  that 
competition  could  not  be  even  approximately  complete,  unless  the 
buyers  contributed  to  the  result.  So,  since  the  utmost  probable  effort 
on  the  part  of  buyers  could  scarcely  suffice  to  get  their  bids  before 
all  sellers,  unless  the  latter  did  something  to  help  in  the  process, 
competition  on  the  buyers'  side  could  not  be  complete,  unless 
sellers  contributed  in  some  degree  to  the  result.  In  other  words, 
complete  competition  within  either  group  requires  that  there  shall 
be  alertness,  openness  of  mind,  and  enterprise  in  the  opposite  group. 

Assumptions. — The  abstract  and  hypothetical  character  of 
value  theory  has  already  been  remarked.  We  start  with  a  few 
assumptions  respecting  the  causes  and  conditions  present  and  respect- 
ing their  uniformity  of  action ;  and,  on  the  basis  of  these  assumptions, 
work  out  a  body  of  doctrine  with  respect  to  the  processes  and 
principles  by  which  prices  are  determined.  Let  us  now  give  a 
moment  to  comment  upon  the  assumptions  which  are  actually  em- 
ployed by  the  economists  in  connection  with  this  task. 

A  Purely  Economic  Individual. — We  assume,  first,  that  each 
man  taking  part  in  the  exchange  process  is  an  ideal  or  perfect 
economic  man.  His  feelings  and  motives  are  predominantly,  if  not 
wholly,  concerned  with  getting  the  maximum  of  satisfactions  for 
himself,  and  they  consistently  remain  so  from  day  to  day  and  year 


25o  PRINCIPLES  OF  ECONOMICS  [XIX 

to  year,  all  other  motives  such  as  charity  and  sympathy  being  shut 
out.  The  man  has  also  full  knowledge  of  market  conditions  and 
excellent,  not  to  say  perfect,  judgment  in  making  decisions.  And 
his  actions  are  entirely  free  of  caprice,  passion,  and  prejudice,  so 
that  he  would  naturally  buy  always  in  the  cheapest  market  and  sell 
in  the  dearest. 

A  Perfect  Market. — The  assumption  of  a  perfect  economic 
man  naturally  carries  with  it  the  assumption  of  a  perfect  market 
where  the  man's  operations  are  performed.  In  this  market  every 
seller  is -supposed  to  be  successful  in  putting  before  every  buyer 
the  particular  opportunity  he  is  offering,  and  every  buyer  is  sup- 
posed to  be  successful  in  putting  before  every  seller  the  opportunity 
which  his  desire  to  purchase  creates.  .  In  other  words,  perfect  com- 
petition is  present  in  such  a  market.  The  most  essential  features 
of  such  a  market  would  be,  first,  extensive  and  efficient  means  of 
gaining  information  and  disseminating  it  among  buyers  and  sellers, 
and,  second,  conditions  favorable  for  allowing  men  to  act  ration- 
ally on  the  information  received.  Finally,  this  perfect  economic 
man  in  the  perfect  market  is  supposed  to  carry  the  principle  of 
competition  to  its  logical  conclusion — to  continue  competing  so  long 
as  there  is  a  surplus  of  immediate  economic  advantage  over  the 
sacrifices  made. 

Perfect  Competition  Is  Not  Unlimited  Competition. — At  this 
point,  however,  it  is  important  to  note  that  the  perfect  competition 
of  economic  science  does  not  involve  the  idea  of  a  competition 
which  is  without  limits,  a  competition  which  defeats  one's  rivals  at 
whatever  the  cost.  It  does  not  include  such  conduct  as  underselling 
a  rival  even  at  a  loss  in  order  to  accomplish  some  ulterior  purpose, 
for  example,  to  punish  him  for  a  personal  injury  or  to  drive  him 
out  of  business.  The  competition  of  economics  is  a  competition  which 
is  directed  to  the  gaining  of  an  economic  advantage  derivable  from 
the  opportunity  to  make  a  particular  sale  or  purchase.  This  means 
that,  on  the  one  hand,  the  seller  will  continue  to  lower  his  price 
until  he  gets  for  his  commodity  no  more  than  it  costs  him  (including 
a  profit  to  himself),  but  no  longer  than  this;  and,  on  the  other  hand. 


XIX]  VALUE  AND  PRICE:  PRELIMINARY 


251 


that  the  buyer  will  continue  to  raise  his  bid  until  he  pays  for  the 
commodity  as  much  as  it  is  worth  to  him,  but  no  longer.  It  is  only 
on  competition  when  understood  in  this  sense,  that  the  principles 
of  price  to  be  explained  in  the  following  chapters  are  founded.  They 
assume  that  competition  will  always  cease  when  the  immediate 
economic  gain  is  completely  eliminated.  Cut-throat  competition, 
predatory  competition,  to  use  a  term  having  much  vogue  in  recent 
years,  is  not  included  in  the  competition  of  economic  theory. 

Discrepancies  between   These  Assumptions  and   Reality. — 

Now,  as  everyone  knows,  the  ideal  conditions  described  are  never 
fully  realized  in  any  actual  exchange  situation. 

Men  are  influenced  by  motives  other  than  the  economic,  their 
knowledge  and  judgment  are  imperfect  and  their  actions  incon- 
sistent. The  perfect  market,  too,  is  rarely  if  ever  to  be  found.  The 
great  exchanges  which  provide  our  nearest  approach  to  it,  have 
ample  means  of  disseminating  information ;  but  they  often  fall 
short  in  other  respects,  because  the  excitement,  the  rumors,  the 
tendency  to  imitation — these  and  other  conditions  which  flourish 
among  a  large  number  of  men  gathered  in  the  same  room — cause 
buyers  and  sellers  to  act  without  rationality.  Moreover,  we  know 
that  the  pure  competition  of  the  economic  hypothesis  is  only  partially 
realized,  being  at  times  replaced  by  monopoly  on  the  one  hand  or 
unbridled  competition  on  the  other. 

Legitimacy  of  Our  Procedure. — But,  although  these  ideal 
conditions  are  never  entirely  realized,  we  are  compelled,  if  we  wish 
to  make  any  progress  at  all  in  our  science,  to  accept  them  as  the 
fundamental  basis  of  our  reasoning.  The  human  intellect  is  of 
but  limited  reach  and  power ;  and  in  economics,  as  in  any  other 
science,  it  is  quite  incapable  of  studying  simultaneously  all  the  forces 
at  work,  or  all  the  varying  intensities  of  even  one  force.  We  have 
to  study  the  different  forces  separately  and  under  simplified  condi- 
tions, eliminating  many  elements  and  assuming  a  fictitious  purity 
and  uniformity  in  those  retained.  It  should  be  added,  however, 
that  if  this  is  the  only  way  to  make  progress,  it  is  in  economics, 
as  in  other  sciences,  a  perfectly  feasible  way.  It  enables  us  first 


252  PRINCIPLES  OF  ECONOMICS  [XIX 

to  gain  a  knowledge  of  fundamental  principles,  uncon fused  by  ex- 
ceptions. When  we  undertake  to  apply  the  principles  in  actual  life, 
it  may  be  necessary  again  to  take  into  account  the  various  forces 
from  which  our  attention  has  been  abstracted  in  the  purely  eco- 
nomic analysis.  But  after  all,  exceptions  to  the  principles  are  much 
less  important  than  the  principles  themselves;  and,  anyway,  we 
cannot  even  begin  to  understand  the  former  until  the  latter  come 
to  hold  an  assured  place  in  our  minds.  However  abstract,  there- 
fore, however  dependent  upon  imperfect  or  unreal  hypotheses,  the 
principles  constitute  the  deepest,  most  vital  facts  in  actual  price- 
determination,  and  so  must  be  fully  mastered. 


CHAPTER  XX 

MARKET  DEMAND  SCHEDULES 

It  is  a  fact  with  which  probably  everyone  has  some  acquaintance 
that  the  determination  of  price,  in  any  but  its  most  superficial 
aspect,  is  somehow  a  matter  of  demand  and  supply.  Accordingly, 
we  must  now  give  some  attention  to  these  elements.  The  present 
chapter  will  be  devoted  to  a  study  of  demand. 


The  Nature  of  Demand 

By  the  demand  for  any  commodity,  the  economist  means  in 
general  the  quantity  of  that  commodity  which  buyers  stand  ready 
to  take  at  some  specific  price.  In  this  definition  let  us  emphasize, 
first,  the  point  that  demand  is  the  amount  which  buyers  stand  ready 
to  take, — offer  to  take.  That  is,  demand  must  not  be  confused  with 
(i)  the  amount  men  want  on  the  one  hand,  nor  (2)  the  amount 
men  actually  buy  on  the  other.  Demand  must  not  be  confused  with 
the  amount  of  a  commodity  which  men  want.  Mere  want,  mere 
desire,  not  backed  by  buying  power  and  not  brought  to  an  issue 
in  a  decision  to  purchase  if  the  price  is  satisfactory,  does  not  con- 
stitute demand.  The  penniless  man  looking  in  at  the  baker's  window, 
however  hungry,  adds  nothing  to  the  demand  for  bread.  It  is 
plain,  of  course,  that  men's  needs,  wants  and  plans  play  a  vital 
role  in  determining  demand.  Thus,  if  an  electric  company  is  in- 
tending to  use  the  water-power  of  the  Huron  River  on  a  great  scale 
for  supplying  current  to  Detroit  and  other  cities,  the  company  will 
need  a  large  amount  of  copper  wire,  and  so  will  doubtless  come 
on  the  market  to  buy  such  wire.  But  while  needs  and  plans 
constitute  one  condition  of  demand,  they  do  not  constitute  demand 

253 


254  PRINCIPLES  OF  ECONOMICS  [XX 

itself.    Demand  exists  only  when  the  company  stands  ready  to  buy 
the  wire. 

But,  if  we  take  care  not  to  confuse  demand  with  the  amount 
which  people  want  or  need,  we  must  be  equally  careful  to  distinguish 
it  from  the  amount  actually  bought.  Demand  in  the  correct  sense 
might  be  characterized  as  potential  demand;  the  amount  bought, 
as  realised  demand.  Of  course,  the  amount  of  the  commodity  in 
question  which  was  actually  bought  at  a  certain  price  must  have 
been  the  same  as  the  amount  which  men  stood  ready  to  buy  at 
that  price,  else  it  would  not  have  been  bought.  That  is,  realized 
demand  and  potential  demand  at  a  given  price  must  be  equal.  But 
the  meanings  of  the  two  expressions  are  very  different;  and  this 
difference  is  of  great  importance.  Potential  demand,  the  amount  of 
any  commodity  which  men  stand  ready  to  take  at  each  of  many 
different  prices  plays,  a  very  great  part  in  determining  what  price  will 
actually  prevail.  Realized  demand,  on  the  contrary,  is  determined 
by  actual  price  rather  than  helping  to  determine  it. 

A  Conditioning  Price. — A  second  point  in  our  definition  which 
needs  emphasis  is  the  phrase  "at  some  specific  price."  Every  proper 
statement  affirming  the  existence  of  a  demand  must  explicitly  or 
by  implication  represent  this  demand  as  conditioned  on  a  'certain  price. 
Thus,  it  is  proper  to  say,  "The  demand  for  silver  at  55  cents  per 
ounce  is  120,000."  It  is  not  proper  to  say  "The  demand  for  silver 
is  120,000  ounces,"  leaving  out  the  phrase  "at  55  cents  per  ounce," 
except  on  condition  that  both  the  person  making  the  remark  and  the 
one  to  whom  it  is  addressed  already  have  one  particular  price  in 
mind,  as  for  example,  the  price  at  which  sales  are  actually  being 
made  at  the  time  the  statement  appears.  The  grounds  on  which 
this  contention  rests  are  perhaps  sufficiently  evident.  The  affirma- 
tion that  "the  demand  for  silver  is  120,000  ounces,"  strictly  inter- 
preted, ought  to  mean  that  there  is  a  demand  for  120,000  ounces 
of  silver  whatever  be  the  price.  But,  of  course,  no  such  affirmation 
could  reasonably  be  made.  Everyone  knows  without  having  studied 
economics  that,  if  the  demand  for  silver  were  120,000  ounces 
when  the  price  was  55  cents,  it  would  be  smaller  were  price  to 
rise  to  60  cents.  Accuracy,  therefore,  requires  us  to  specify  a  price 


XX]  MARKET  DEMAND  SCHEDULES  255 

whenever  we  affirm  demand  to  be  so  and  so ;  though  it  is  doubtless 
possible  that,  in  any  particular  case,  the  conditioning  price  might 
be  implied  with  sufficient  clearness.  Thus  if  any  person  familiar 
with  business  matters  were  to  make  a  statement  like  the  above,  he 
would  doubtless  mean,  and  other  persons  would  understand  him 
to  mean,  that  the  demand  for  120,000  ounces  existed  at  the  current 
market  price  or  at  some  price  approximately  equal  to  the  market 
price.  But  such  carelessness  of  statement,  trusting  to  mere  im- 
plications, often  misleads  the  uninformed  and  causes  confused  think- 
ing even  with  the  trained  student. 

One  further  point  in  explanation:  Our  definition  implies  that 
the  relation  between  the  volume  of  'demand  and  the  conditioning 
price  is  twofold.  It  means,  first,  that  if  price  is  the  one  named, 
the  demand  will  be  of  the  volume  indicated,  and  secondly,  that, 
only  if  price  is  as  low  as  the  one  named,  will  demand  be  of  the 
volume  indicated.  Accordingly,  if  we  say  that  the  demand  for 
silver  is  120,000  ounces  at  55  cents,  we  should  be  understood  as 
affirming  both  the  following  propositions:  (a)  If  any  person  wishes 
to  insure  that  demand  shall  not  get  as  large  as  120,000  ounces,  he 
must  insure  that  price  does  not  go  as  low  as  55  cents,  (b)  If  any 
person  wishes  to  insure  that  demand  shall  be  as  great  as  120,000 
ounces,  he  must  insure  that  price  does  go  as  low  as  55  cents. 

Demand  Price. — The  point  so  strongly  emphasized  in  the 
preceding  paragraphs,  that  the  appearance  of  a  given  demand  is 
conditioned  on  the  appearance  of  a  given  price,  gives  rise  to  a  con- 
cept of  much  importance  and  one  constantly  in  use,  namely,  that 
of  "demand  price."  In  the  illustrations  just  used,  55  cents  is  as- 
sumed to  be  the  demand  price  of  120,000  ounces  of  silver.  This 
means  that,  if,  and  only  if,  the  actual  price  were  to  become  55  cents, 
would  the  demand  be  120,000  ounces.  Further  study  will  show  us 
that  at  times  this  statement  may  seem  to  need  qualification  be- 
cause of  the  fact  that  demand  may  remain  the  same  at  several 
different  prices,  so  that  any  one  of  these  might  seem  to  be  the 
demand  price,  which  would  amount  to  saying  that  none  was.  It 
will  become  evident  as  we  proceed,  however,  that,  of  these  several 
prices,  only  one  really  conditions  the  appearance  of  the  given  de- 


256  PRINCIPLES  OF  ECONOMICS  [XX 

mand,  and  that,  therefore,  only  one  price  is  really  the  demand  price 
of  the  given  volume  of  demand. 

ILLUSTRATIVE  PROBLEM 

"The  demand  for  labor  is  almost  always  less  than  the  amount  offered." 
Criticize  that  method  of  statement.     Remodel  the  statement  in  two 
or  three  different  ways  to  show  what  the  writer  might  have  meant. 

II 
The  Dependence  of  Demand  on  Price 

In  the  preceding  discussion,  it  was  shown  that  the  quantity  of 
demand  is  conditioned  upon  price.     We  must  now   explain  this 

0  40  80  120  160  200 

1  i    i    i    I    i    i    i    I   i    i    i    I    i    i    i    I    i    i    i    I    i 


55— 


Figure  i.    Demand  Dependent  on  Price  A 


conditioning  more  fully.  Let  us  suppose  that,  on  a  certain  day,  the 
demand  for  silver  at  a  price  of  55  cents  is  just  120,000  ounces  as 
in  our  last  illustration.  This  quantity  is  represented  in  the  accom- 
panying diagram  by  the  shaded  rectangle, — the  vertical  scale  at  the 
left  indicating  the  price  in  cents  and  the  horizontal  scale  at  the 
top  indicating  the  number  of  ounces  in  thousands.  The  arrow  at 
the  left  pointing  from  the  figure  55  toward  the  rectangle  is  in- 
tended to  bring  out  the  idea  that  the  price  of  55  cents  is  the  im- 
mediate condition  or  cause  which  insures  that  the  demand  shall 
be  the  amount  indicated.  Now,  starting  with  this  hypothesis  that 
120,000  ounces  are  demanded  at  55  cents,  we  may  be  quite  sure 
that  the  same  persons  who  stand  ready  to  buy  that  amount  at  the 
price  stated,  or,  anyhow,  some  other  persons,  are  ready  to  buy, — 
have  the  mental  attitude  needed  to  induce  them  to  buy, — say,  10,000 
ounces  more  at  a  price  of  54  cents ;  40,000  ounces  more  at  price  of 
53  cents;  80,000  ounces  more  at  a  price  of  52  cents;  and  so  on. 
That  is,  right  alongside  of  the  120,000  demand  which  would  be 


XX]  MARKET  DEMAND  SCHEDULES  257 

realized  if  a  price  of  55  cents  were  reached,  and  a  part  of  the  same 
general  situation,  we  have  various  other  potential  demands  which 
would  just  as  surely  be  realized  if  lower  prices  were  established. 
In  Figure  2,  we  have  these  other  demands  presented  along  with  de- 
mand at  the  55-cent  price. 

But,  not  only  is  it  involved  in  the  demand  situation  that  larger 
amounts  would  be  taken  were  the  price  lower  than  55  cents;  the 
complementary  statement  is  also  true.  Given  the  present  mental 
attitude  of  buyers,  the  amount  demanded  by  them  would  be  smaller 
if  price  were  higher  than  55  cents,  instead  of  lower.  Thus,  some 

0  40  80  120  160  200 

1  I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I 

66- 
66 
64- 
63- 
62- 
51- 


E$$$^^$^^^ 


*  ^^^^^^^ 

Figure  2.    Demand  Dependent  on  Price—  P. 


of  the  people  whose  offer  to  buy  at  55  cents  aggregated  120,000 
ounces,  would,  if  price  rose  to  56  cents,  withdraw  a  part  or  all  of 
their  former  demand;  they,  or  others,  would  withdraw  still  more 
of  that  demand,  if  price  rose  to  57  cents;  still  more,  if  it  rose  to 
58  cents;  and  so  on.  That  is,  as  a  part  of  the  same  general  situa- 
tion from  which  we  set  out,  we  have  a  series  of  potential  demands 
at  prices  above,  as  well  as  at  prices  below,  the  assumed  one  of  55 
cents.  Supposing  these  demands  to  be  110,000  ounces  at  56  cents, 
80,000  ounces  at  57  cents,  40,000  at  58  cents,  and  so  on,  and  com- 
bining them  with  the  demands  indicated  in  our  last  diagram,  we 
should  have  the  result  represented  in  Figure  3. 

The  Demand  Schedule. — We  are  now  prepared  to  explain 
the  meaning  of  a  phrase  which  will  be  frequently  used  in  the  follow- 
ing pages, — the  phrase  "demand  schedule."  Demand,  as  we  have 
just  seen,  is  always  relative  to  a  particular  price  stated  or  implied, 


258 


PRINCIPLES  OF  ECONOMICS 


[XX 


and  the  amount  of  demand,  generally  speaking,  varies  inversely 
though  not  proportionally  to  price:  the  lower  the  price,  the  greater 
the  demand;  the  higher  the  price,  the  smaller  the  demand.  It 
follows  that  the  facts  of  demand  at  any  time  require  for  their  ade- 


0  40  80  120  160  200 

1  I    I    I   I    I    I    I    I    I    I    I    I    l    I    I    I    I    I    I    I    I 


69- 
68- 
67- 
66- 
55— 
54- 
63- 
62- 
61- 


Figure  3.    Demand  Dependent  on  Price  —  C 


quate  statement  a  series  of  conditional  propositions.    Thus,  the  sup- 
posed case  for  silver  would  be  most  adequately  stated  as  follows  : 

The  demand  would  be  40,000  oz.  if  price  were  as  low  as  58  cents 
The  demand  would  be  80,000  oz.  if,  and  only  if,  price  were  as  low  as  57  cents 
The  demand  would  be  110,000  oz.  if,  and  only  if,  price  were  as  low  as  56  cents 
The  demand  would  be  120,000  oz.  if,  and  only  if,  price  were  as  low  as  55  cents 
The  demand  would  be  130,000  oz.  if,  and  only  if,  price  were  as  low  as  54  cents 
The  demand  would  be  160,000  oz.  if,  and  only  if,  price  were  as  low  as  53  cents 
The  demand  would  be  200,000  oz.  if,  and  only  if,  price  were  as  low  as  52  cents 

Such  a  series  of  propositions,  we  call  a  demand  schedule.  In  order 
to  abridge  the  statement  of  it,  we  will  put  it  in  the  form  of  two 
columns  of  figures  with  the  proper  headings,  Price  and  Demand, 
as  shown  in  Table  i.  The  student  must  always 
remember,  however,  that  it  is,  in  effect,  a  series 
of  conditional  statements,  such  as  those  already 
given. 

A  demand  schedule  of  the  general  type  just 
presented  probably  comes  nearer  to  represent- 
ing the  facts  of  experience  than  would  a  more 
symmetrical  one.  But  as  our  purpose  in  using 


TABLE  i 


PRICE 
CENTS 

58 

57 

56 

55 

54 

53 

52 


DEMAND 

ooo  oz. 

40 

80 

1 10 

1 20 

130 

160 

200 


XX]  MARKET  DEMAND  SCHEDULES  259 

these  schedules  is  primarily  pedagogical,  we  shall  change  this  one  to 
a  form  which  can  be  used  more  effectively  in  clearing  up  the  theory 
of  price.     In  this  new  schedule,  the  variations 
of  demand  consequent  upon  changes  in  price  TABLE  2 

are  represented  as  uniform,   10,000  ounces   in     PRICE  DEMAND 

each  instance.     Thus  altered,  and  carried  both     CE?^S  °°°  oz* 

higher  and  lower,  our  schedule  will  appear  as        59  go 

in  Table  2.     In  diagrammatic  form  it  is  pre-        58  90 

A     '         TT-  57  100 

sented  in  Figure  4.  56  no 

55  120 

Real   Changes  in   Demand. — One  further        53  I40 

point  which  should  be  noted  before  we  •  leave 
this  immediate  topic  is  a  possible  ambiguity  in        so  170 

our  use  of  such  expressions  as  "demand  has 
changed,"  "demand  has  increased,"  "demand  has  diminished,"  etc. 
Usually  we  mean,  perhaps  always  ought  to  mean,  that  the  whole  de- 
mand schedule  has  changed, — at  each  of  the  prices  of  the  schedule, 
demand  is  different  from  what  it  was.  Such  a  change  is  a  real 
change  in  the  demand  situation  and  is  sure  to  cause  a  change  in  price 
unless  some  other  change  in  the  conditions  neutralizes  this  one.  But 
not  seldom  people  say  that  demand  has  changed,  when  they  mean 
merely  that  another  part  of  the  existing  demand  schedule  has  been 
realised  because  actual  price  has  changed  and  so  fulfilled  the  con- 
dition necessary  to  make  that  part  effective.  Such  a  change  is  not 
really  a  change  in  demand  at  all.  The  total  demand  situation  is 
just  what  it  was  before;  since,  as  we  have  already  indicated,  the  de- 
mand of  any  one  moment  is  not  just  the  demand  at  one  particular 
price,  but  the  whole  series  of  demands  at  a  series  of  prices,  which 
demands  and  prices  together  embody  or  express  the  total  demand 
situation. 

In  order  to  avoid  the  ambiguity  just  referred  to,  it  might  be  well 
to  use  the  expression  "the  demand  schedule  has  changed,"  when 
we  mean  that  demand  at  the  same  prices  has  changed.  As  we  shall 
see,  a  general  change  in  the  demand  schedule,  not  in  just  one  item 
of  demand,  is  really  necessary  to  bring  about  a  change  in  price; 
and  so  this  method  of  expression  would  be  more  adequate  than  any 
other.  But  it  would  probably  be  futile  to  attempt  to  make  such 


26o 


PRINCIPLES  OF  ECONOMICS 


[XX 


a  change  in  usage.    We  must,  therefore,  be  careful  not  to  confuse 
the  two  possible  meanings  of  "changes  in  demand." 


55- 


40 


80 


120 


160 


50- 


The  Inverse  Elasticity  of  Demand. — Since  the  points  estab- 
lished in  the  preceding  discussion  are  of  much  importance  in  later 
connections,  we  will  give  them  the  emphasis  derived  from  definite 
formulation  in  a  principle. 


Principle 
Demand. 


-The  Law  of  the  Inverse  Elasticity  of 


Demand  is  always  relative  to  a  particular  price  ex- 
pressed or  implied,  and,  broadly  speaking,  varies  inversely 
as  said  price,  though  not  proportionally. 

ILLUSTRATIVE  PROBLEM 

"The  statement  'price  depends  on  supply  and  demand'  is  not  the 
whole  truth;  it  is  equally  true  that  'supply  and  demand  depend  on 
price.' " 


XX]  MARKET  DEMAND  SCHEDULES  26l 

Comment:  The  impression  naturally  received  from  the  above  state- 
ment— that  the  two  propositions  contrasted  are  really  coordinate  proposi- 
tions, that  supply  and  demand  on  the  one  hand  and  price  on  the  other 
are  reciprocally  dependent — is  quite  erroneous.  The  supply  and  demand 
which  are  dependent  on  price  are  not  the  supply  and  demand  on  which 
price  is  dependent.  The  latter  are  the  supply  and  demand  schedules,  the 
total  supply  and  demand  situations  of  any  moment;  the  former  are  the 
particular  parts  of  a  given  supply  or  demand  schedule  which  corre- 
spond to  the  different  prices.  An  increase  in  supply  (the  supply  schedule) 
will  cause  a  fall  in  price,  other  things  being  equal.  A  fall  in  price, 
however,  does  not  cause  a  real  decrease  in  the  supply  (the  supply  sched- 
ule) ;  it  merely  brings  into  operation  a  different  part  of  the  same  un- 
changing supply  schedule. 

Explain  and  defend  that  statement. 

Ill 

The  Interpretation  of  Demand  Schedules 

Demand  Schedules  Composite. — As  we  shall  have  frequent 
occasion,  during  our  study  of  the  theory  of  price,  to  make  a  dis- 
criminating use  of  demand  schedules,  it  is  very  important  that,  at 
the  outset,  we  should  gain  familiarity  with  the  true  nature  and 
significance  of  these  schedules  and  their  various  parts.  First,  it  is 
to  be  noted  that  demand  at  any  particular  price  is  a  composite  made 
up  of  many  sections  or  increments,  each  one  of  which,  except 
the  last,  would  appear  at  some  higher  price.  To  clear  this  up,  let 
us  start  with  the  lowest  line  in  our  demand  schedule  on  page  259, 
the  demand  at  50  cents.  Manifestly,  this  170,000  ounces  consists 
of  the  10,000  which  came  in  only  when  price  fell  to  50  cents,  added 
to  the  160,000  already  wanted  at  51  cents.  But  the  160,000  ounces, 
in  turn,  consists  of  the  10,000  which  came  in  at  51  cents,  added 
to  the  150,000  already  wanted  at  52  cents.  And  the  150,000  ounces, 
again,  is  the  10,000  coming  in  at  52  cents  added  to  the  140,000 
wanted  at  53  cents — and  so  we  might  continue  all  the  way  to  the 
top  of  the  schedule.  Accordingly,  the  170,000  ounces  wanted  at 
50  cents  is  the  sum  of  all  the  increments  of  demand  which  would 
successively  appear,  if  price  were  to  pass  through  all  stages  from  the 
highest  to  the  lowest.  The  point  just  made  is  graphically  pre- 


262 


PRINCIPLES  OF  ECONOMICS 


[XX 


sented  in  Figure  5,  where  the  small  letters  represent  the  successive 
additions  to  demand  which  are  supposed  to  appear  at  each  price. 
Thus,  q  comes  in  at  50  cents  itself ;  p  came  down  from  51  cents ; 
o,  from  52  cents;  n,  from  53  cents;  m,  from  54  cents;  /,  from 
55  cents ;  and  so  on. 

Included  and  Excluded  Increments. — Another  important  mat- 
ter concerns  the  different  divisions  into  which  the  various  sections 


40 


80 


120 


160 


65- 


60- 


1     1                 1 

a 

b 

c 

d 

e 

f 

g 

h 

i 

3 

k 

a 

b 

c 

d 

e 

f 

g 

h 

i 

j 

k 

,1 

a 

b 

c 

d 

e 

f 

g 

h 

i 

| 

k 

1 

3 

a 

b 

c 

d 

e 

I 

g 

h 

i 

i 

k 

1 

m    n  1 

a 

b 

c 

d 

e 

f 

g 

h 

i 

j 

k 

1 

m    n    o 

a 

b 

c 

d 

e 

f 

g 

h 

i 

3 

k 

1 

m    n    o    p 

a 

b 

c 

d 

e 

f 

g 

h 

i 

3 

k 

1 

m    n    o    p     q 

Figure  5.    Demand  Schedules  Composite 


or  increments  of  demand  group  themselves  when  any  particular 
price  has  been  established.  The  first  break  occurs  between  the 
excluded  increments  and  the  included  ones.  Thus,  if  price  proves  to 
be  55  cents,  all  the  increments  of  demand  which  depend  upon  a  price 
lower  than  this  will,  of  course,  be  shut  out;  while  all  increments 
which  depend  upon  this  or  a  higher  one  will  be  included,  for  the 
man  who  was  ready  to  buy  at  56  cents  or  57  cents  or  58  cents  will 
surely  be  in  the  same  frame  of  mind  if  price  falls  to  55  cents. 

Marginal,  Intra-Marginal,  Extra-Marginal. — A  still  more 
useful  classification  of  the  different  increments  of  demand  takes  as 
its  starting  point  a  particular  one  of  the  included  increments — called 
the  marginal  increment — and  divides  all  others  into  two  groups,  one 


XX]  MARKET  DEMAND  SCHEDULES  263 

inside  and  one  outside  this  marginal  increment.  The  one  chosen 
for  our  starting  point — the  marginal  increment — is  the  last  of  the 
included  ones,  the  last  to  appear  when  an  actual  price  of  55  cents 
was  being  established.1  In  conceiving  this  idea,  however,  we 
should  not  emphasize  the  time  aspect  of  the  matter.  For  it  is  quite 
possible  that,  as  a  matter  of  fact,  the  marginal  increment  came  in 
earlier  than  some  of  the  other  included  ones,  though  it  would  not 
have  done  so  had  the  conditions  all  been  what  they  are  now.  That 
is,  the  real  point  involved  is  that  the  marginal  increment  is  the  in- 
crement which,  in  view  of  all  the  conditions  present,  would  be 
expected  to  come  in  last, — the  one  which  the  conditions  at  work 
would  naturally  cause  to  come  in  last.  At  what  stage  it  did  actually 
appear  is  a  matter  of  no  moment.  This  aspect  of  the  case  frequently 
leads  the  economist  to  substitute  for  this  method  of  characterizing 
the  marginal  increment,  one  which  represents  it  as  the  increment 
which  would  be  the  first  to  drop  out  if  price  should  rise. 

Since  we  have  chosen  to  designate  the  increment  of  demand 
which  would  naturally  have  come  in  last  or  would  naturally  go  out 
first — that  is  the  increment  which  lies  at  the  boundary  line  between 
included  increments  and  excluded  ones — the  marginal  increment, 
we  naturally  designate  all  other  included  increments, — all  those 
inside  the  marginal  one — intra-marginal  increments ; 2  while  all  ex- 
cluded ones — all  outside  the  marginal — we  call  extra-marginal  in- 
crements. As  will  appear  in  a  later  chapter,  only  two  among  all 
these  various  increments  of  demand  play  an  immediate,  direct  part 
in  the  determination  of  price,  namely:  the  marginal  and  first  extra- 
marginal. 

The  location  of  these  various  increments  of  demand  is  brought 
out  in  Figure  6.  The  rectangle  opposite  each  price  figure  repre- 
sents the  included  demand,  the  demand  which  would  appear  if  that 
price  were  established;  the  space  beyond  the  rectangle  included 


a  It  may  help  us  to  realize  the  true  nature  of  this  concept  of  marginal 
increment,  as  also  several  other  very  important  concepts  in  which  the  marginal 
idea  is  present,  if  we  think  of  the  marginal  increment  as  that  one  of  the 
included  increments  which  comes  just  before  we  are  through  them,  just 
before  we  pass  to  the  excluded  ones.  It  is,  so  to  speak,  at  the  margin  of 
the  lake,  just  before  we  reach  the  shore. 

a  Sometimes  designated  ,yM/>ra-marginal. 


264 


PRINCIPLES  OF  ECONOMICS 


[XX 


between  the  dotted  lines  represents  the  excluded  demand,  the  demand 
which  at  a  given  price  would  be  shut  out.  The  demand  excluded 
at  any  price  is  of  course  made  up  of  demands  which  would  appear 
at  lower  prices.  The  figure  opposite  the  55-cent  price  represents 
a  condition  of  things  brought  about  by  an  actual  price  of  55  cents. 
0  40  80  120  160 


60- 


55- 


50- 


1   1    1 

1    1    1 

1    1    1 

1   1   1 

1 

Figure  6.    Increments  of  Demand  Schedule  Classified — A 


The  included  demand  is  shaded  as  well  as  being  bounded  by  the 
continuous  lines;  while  the  excluded  demand  is  represented  by  the 
space  between  the  heavy  dotted  lines.  The  square  cut  off  from  the 
right-hand  end  of  the  shaded  rectangle  and  further  marked  by  the 
inclosed  square  stands  for  the  marginal  increment  of  demand,  the 
increment  which  last  comes  in  when  actual  price  becomes  55  cents. 
Since  all  demands  outside  this  one  are  extra-marginal  ones  as  well 
as  excluded  ones,  the  space  between  the  dotted  lines  represents  such 
extra-marginal  demands.  The  square  cut  off  from  the  left-hand 
end  of  this  space  and  further  distinguished  by  the  inclosed  circle 


XX] 


MARKET  DEMAND  SCHEDULES 


265 


represents  the  first  extra-marginal  increment  of  demand.  This  in- 
crement of  demand  is  obviously  the  same  as  the  one  which  would 
come  in  if  actual  price  were  to  fall  to  54  cents,  that  is,  at  54  cents 
it  would  be  the  marginal  increment  of  demand.  It  may  therefore 
be  represented  in  our  diagram  by  the  square  cut  off  from  the  right- 
hand  end  of  the  54-cent  rectangle  and  having  a  small  square  in- 

0  40  80  120  160 

I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I    I 


60— 


55 — 


50 — 

Figure  7.     Increments  of  Demand  Schedule  Classified — B 

scribed.     Its  representation  in  the  55-cent  figure,  however,  brings 
out  better  its  character  as  extra-marginal. 

Different  Demand  Prices. — On  page  256  it  was  explained 
that  the  particular  price  which  was  necessary  to  bring  out  any 
particular  amount  of  demand  is  known  as  the  demand  price  of  that 
amount  of  demand.  In  the  case  before  us,  therefore,  55  cents  is 
the  demand  price  for  120,000  ounces  of  silver.  But  it  is  also  plain 
that  55  cents  is  in  a  peculiar  sense  the  demand  price  of  the  marginal 


266  PRINCIPLES  OF  ECONOMICS  [XX 

increment  of  demand,  the  10,000  ounces  which  would  come  in  only 
when  price  fell  to  that  point.  Being  thus  the  demand  price  of  the 
marginal  increment  of  demand,  it  is  very  naturally  called  the  mar- 
ginal demand  price.  In  like  manner,  54  cents,  the  price  which  would 
be  necessary  to  bring  out  the  first  extra-marginal  increment,  the 
increment  which  would  come  in  only  if  price  fell  to  that  point,  is 
naturally  called  the  first  extra-marginal  demand  price. 

To  give  our  ideas  with  respect  to  these  de- 

DEMAND  PRICE  ,  .    -   .  .    .      ,     .     , . 

ooo  oz.  CENTS    mand  prices  greater  dejimteness,  it  is  desirable 

50  62  t0  deal  with  demand  schedules  in  which  demand 

70  go  is  supposed  to  remain  constant  through  several 

80  59  prices;  for  such  a  schedule  makes  possible  a 

go  sharp  separation  of  actual  price,  marginal  de- 

80  56  mand  price,  and  first  extra-marginal  demand 

Qf\  C  C 

80  54         price.3    A  schedule  of  this  sort  is  represented 

9°  53         in  the  accompanying  table  and  in  Figure  7, — 

100  52  ,  .   .        .  ... 

IIO  ej         demand    remaining   just   00,000   ounces    while 

actual  price  ranges  from  59  cents  down  to  54 
cents.  Under  this  schedule,  if  actual  price  were  56  cents,  the  mar- 
ginal demand  price  would  be  59  cents,  since  this  is  the  price  which 
brought  in  the  last  increment  of  demand;  while  the  first  extra- 
marginal  demand  price  would  be  53  cents,  since  this  is  the  price 
necessary  to  bring  in  an  extra-marginal  increment  of  demand.  Fur- 
ther, the  marginal  demand  price  would  continue  to  be  59  cents,  and 
the  first  extra-marginal  demand  price  would  still  be  53  cents,  so  long 
as  price  was  not  more  than  59  cents  nor  less  than  54  cents. 

As  a  matter  of  course,  we  often  have  occasion  to  apply  the  terms 
marginal,  extra-marginal,  and  intra-marginal  to  buyers.  Marginal 
buyers  are  those  who  make  some  or  all  of  their  purchases  only 
when,  and  because,  actual  price  has  fallen  to  the  marginal  demand 
price;  or  marginal  buyers  are  those  included  buyers  who  would  be 
the  first  to  drop  out  of  the  market  if  the  price  should  rise.  In  other 
words,  the  marginal  buyers  are  the  ones  who  are  responsible  for 


*As  we  shall  learn  in  a  later  chapter,  long-time  demand  schedules, — 
schedules  which  sum  up  the  demand  facts  for  a  whole  period — often  show 
this  peculiarity. 


XX]  MARKET  DEMAND  SCHEDULES  267 

the  marginal  increment  of  demand.  So,  the  intra-marginal  buyers 
are  the  ones  responsible  for  the  intra-marginal  increments  of  de- 
mand. Their  purchases  would  be  assured,  even  if  price  were  higher 
than  it  proves  to  be.  The  extra-marginal  buyers  are  the  ones 
responsible  for  the  extra-marginal  increments  of  demand.  They 
make  no  purchases  and  are  frequently  called  the  excluded  buyers. 

yypo    .  • 

ILLUSTRATIVE  PROBLEMS 

1.  Suppose  that  on  the  second  Saturday  of  October  a  section  of  the 
demand  schedule  for  wood  in  Ann  Arbor  is  as  follows :  i  cord  wanted 
at  $6 ;  2  at  $5.75 ;  4  at  $5.50 ;  3  more  at  $5.25 ;  3  more  at  $5 ;  7  more  at 
$4.75 ;  8  more  at  $4.50 ;  and  so  on.     Put  this  into  tabular  form. 

2.  Suppose  that  the  conditions  of  demand  for  Milton's  autographs 
are  such  that  i  would  be  wanted  if  the  price  were  $200;  2  if  price  were 
$175;  4  if  $150;  5  if  $140;  8  if  $125;  9  if  $110;     DEMAND  PRICE 
12  if  $100 ;   13  if  $90;   15  if  $75;  and  20  if  $50.       ooo  oz.            CENTS 

Put  this  demand  schedule  into  tabular  form. 

70  07 

(If  the  problem  had  said:  i  wanted  at  $200;  7O  66 

2  at  $175;   and  so  on,  it  would  have  meant  the  7°  65 

same  thing.)  g  64 

3.  Suppose  that  the  demand  schedule  for  sil-         I0°  ^2 

100  61 

ver  at  a  certain  time  is   represented  by  the  ac-         IOO  50 

companying  table,  answer  the  following :  100  59 

107  58 

120  57 

(a)  Interpret  the  first  three  lines;  the  last  five         I2O  55 

lines.  120  55 

(b)  What  would  be  the  marginal  increment 

of    demand   if    actual    price    were    67   cents?     65         ^  52 

cents?    63  cents?     59  cents?    57  cents?    55  cents?        i53  Si 

(c)  What  would  be  the  first  extra-marginal  increment  of  demand  if 
actual  price  were  66  cents  ?     65  cents  ?     61  cents  ?     59  cents  ?     54  cents  ? 

(d)  What  would  be  the  marginal  demand  price  if  actual  price  were 
67  cents?     66  cents?     63  cents?     60  cents?     56  cents?     52  cents? 

(e)  What  would  be  the  first  extra-marginal  demand  price  if  the 
actual  price  were  65  cents  ?    66  cents  ?     67  cents  ?     63  cents  ? 

(f)  Who  would  be  the  marginal  buyers  if  actual  price  were  66 
cents?     53  cents?     55  cents?     60  cents?     54  cents? 

(g)  Who  would  be  the  first  extra-marginal  buyer  if  actual  price 
were  66  cents?     65  cents?     61  cents?     58  cents?     56  cents?     52  cents? 


CHAPTER  XXI 

MARKET  SUPPLY  SCHEDULES 

I 
The  Nature  of  Supply 

We  have  considered  one  of  the  two  most  essential  elements  in 
price-determination,  demand ;  we  must  now  take  up  the  second, 
supply.  In  general,  we  shall  understand  the  supply  of  any  com- 
modity to  mean  the  quantity  of  that  commodity  which  sellers  stand 
ready  to  dispose  of  at  some  specific  price. 

Supply  and  Stock. — Here  we  need  to  emphasize,  first,  the 
statement  that  supply  is  the  amount  which  sellers  stand  ready  to  dis- 
pose of.  In  particular,  the  supply  of  anything  should  not  be  con- 
fused either  (i)  with  the  total  amount  in  the  hands  of  producers 
or  dealers,  or  (2),  on  the  other  hand,  with  the  amount  actually  sold. 
Supply  should  not  be  confused  with  the  total  amount  in  the  hands 
of  producers  or  dealers.  This  total  we  call  stock;  and  only  a  part 
of  it  constitutes  supply, — so  much  of  it  as  people  stand  ready  to 
sell  at  some  price  or  other.  But,  though  stock  is  not  the  same  as 
supply,  it  is  of  course  the  immediate  source  of  supply,  and,  there- 
fore, does  much  in  determining  supply.  On  the  one  hand,  it 
always  sets  an  upward  limit  to  supply.  On  the  other  hand,  it  exists 
only  to  become  supply,  and  so  must  ultimately  make  supply  as  large 
as  itself.  The  supply  of  wheat  in  the  market  today  may  be  only 
10,000,000  bushels,  though  the  stock  is  1,000,000,000  bushels;  but, 
in  the  course  of  the  season,  most  of  the  1,000,000,000  bushels  is 
bound  to  be  offered  for  sale,  and,  therefore,  taking  the  season  as  a 
whole,  the  supply  is  certain  to  become  substantially  coincident  with 
the  stock.1 


1  The  distinction  between  stock  and  supply  is  more  particularly  applicable 
in  the  discussions  of  the  next  chapter.     When  we  come  to  consider  normal 

268 


XXI]  MARKET  SUPPLY  SCHEDULES  269 

Again,  supply  must  not  be  confused  with  the  amount  actually 
sold.  The  reason  is  analogous  to  that  which  was  given  to  show 
that  we  should  not  confuse  demand  with  the  amount  bought.  As 
a  matter  of  fact,  "the  amount  which  people  stand  ready  to  dispose 
of"  may  be,  but  need  not  be,  equal  to  "the  amount  which  is  actually 
sold."  But,  even  if  the  two  were  always  quantitatively  equal,  the 
meaning,  the  connotation  of  the  two  phrases  would  be  different. 
"The  amount  which  sellers  stand  ready  to  dispose  of"  plays  a  very 
great  part  in  determining  price;  but  "the  amount  actually  sold"  is 
itself  determined  after  price  is  determined. 

A  Conditioning  Price. — A  second  point  in  our  definition 
which  needs  emphasis  is  suggested  in  the  phrase  "at  some  specific 
price."  No  statement  affirming  the  existence  of  a  given  volume 
of  supply  can  be  recognized  as  adequate  unless  it  represents  supply 
as  conditional  on  some  particular  price.  Thus,  it  is  proper  to  say, 
"The  supply  of  silver  is  120,000  ounces  at  55  cents  an  ounce";  but 
unless  the  current  market  price  is  implied  and  understood,  it  is  not 
proper  to  say,  "The  supply  of  silver  is  120,000  ounces."  For  the 
latter  statement,  literally  interpreted,  means  that  sellers  stand  ready 
to  dispose  of  120,000  ounces  whether  the  price  be  low  or  high; 
and  such  a  statement  would  in  most  cases  be  absurd  indeed. 

In  analogy  with  the  case  of  demand,  this  conditioning  relation 
between  actual  price  and  the  volume  of  supply  gives  rise  to  a  special 
concept  of  great  importance,  namely :  that  of  "supply  price."  This 
means,  of  course,  the  particular  price  which  is  necessary  to  bring 
out  the  marginal  increment  of  a  particular  volume  of  supply  and, 
therefore,  is  necessary  to  bring  out  that  volume  as  a  whole. 

II 
The  Dependence  of  Supply  on  Price 

Supply  Schedules. — We  have  just  seen  that  supply,  like 
demand,  is  always  relative  to  a  specific  price.  We  must  now  ex- 
plain this  relation  more  precisely.  First,  the  facts  of  supply,  like 


price,  the  price  which  tends  to  prevail  over  some  considerable  period,  we 
usually  have  to  regard  supply  as  conterminous  with  stock. 


270  PRINCIPLES  OF  ECONOMICS  [XXI 

those  of  demand,  require  for  their  complete  presentation  a  supply 
schedule,  a  series  of  statements  giving  the  amount  of  supply  at  each 
of  a  series  of  prices.  This  follows  from  the  fact  already  brought 
out  that  the  volume  of  supply  is  always  relative  to  price.  In  the 
second  place,  though  supply  is  like  demand  in  the  sense  that  its 
volume  is  relative  to  price,  the  supply  changes  which  follow 
changes  in  price  are  exactly  opposite  to  the  demand  changes. 
The  volume  of  supply  increases  as  price  rises,  and  diminishes  as 
price  falls,  whereas  the  volume  of  demand,  as  we  have  seen,  dimin- 
ishes as  price  rises  and  increases  as  price  falls.  In  short,  supply 
varies  directly,  though  not  proportionally,  as  price.  Accordingly,  the 
supply  of  any  commodity  should  always  be  conceived  as  a  series 
of  different  supplies,  each  one  of  which  is  conditioned  on  one  par- 
ticular price.  A  series  of  this  sort  we  call  a  supply  schedule.  Such 
a  supply  schedule  for  silver  analogous  to  the  demand  schedule  given 
on  page  258  would  read  as  follows : 

The  supply  would  be  200,000  oz.  if,  and  only  if,  price  were  as  high  as  58  cents 
The  supply  would  be  160,000  oz.  if,  and  only  if,  price  were  as  high  as  57  cents 
The  supply  would  be  130,000  oz.  if,  and  only  if,  price  were  as  high  as  56  cents 
The  supply  would  be  120,000  oz.  if,  and  only  if,  price  were  as  high  as  55  cents 
The  supply  would  be  110,000  oz.  if,  and  only  if,  price  were  as  high  as  54  cents 
The  supply  would  be  80,000  oz.  if,  and  only  if,  price  were  as  high  as  53  cents 
The  supply  would  be  40,000  oz.  if  price  were  as  high  as  52  cents 

As  in  the  case  of  demand,  we  shall  substitute  for  this  schedule 

T  BLE  i  one  Better  adapted  to  the  work  of  explanation, 

that  is,  one  in  which  the  changes  in  volume 

ENTS  ooc>PozY     consequent  on   changes  in  price  are  uniform. 

60  170        Such  a  supply  schedule  for  silver  is  represented 

5|  J5£        in  Table  I  and  in  Figure  i. 

57  MO 

Real  Changes  in  Supply. — The  expression 

54  no        "supply  has  changed"  shows  the  same  fault  of 

ambiguity    that    we    found    in    "demand    has 
51  80        changed."     It  ought  to  mean  that  the  whole 

supply  situation,  the  supply  schedule,  has 
changed.  It  often  does  mean  merely  that  another  part  of  the  exist- 
ing supply  schedule  has  been  realized  because  of  a  change  in  the 
actual  price.  A  change  in  supply  in  the  former  sense  is  sure  to 


XXI] 


MARKET  SUPPLY  SCHEDULES 


271 


cause  a  change  in  actual  price,  unless  neutralized  by  some  other 
change  in  conditions ;  a  change  in  supply  in  the  latter  sense  is  caused 
by  a  change  in  actual  price. 

The  Direct  Elasticity  of  Supply. — The  points  thus  far  ex- 
plained concerning  the  relation  of  supply  to  price,  may  be  put  into 
formal  shape  as  follows: 

0  40  80  120  160 


60- 


55- 


50- 


1    1    1 

1    1    1 

1    1    1 

1    1    1 

1 

Figure  I.     Supply  Schedule 


Principle — The  Law  of  the  Direct  Elasticity  of  Supply. 

Supply  is  always  relative  to  a  particular  price  expressed 
or  implied  and,  broadly  speaking,  varies  directly,  though  not 
proportionally,  as  price.2 


2  Remember  that  we  are  now  dealing  with  the  immediate  supply  schedule, 
the  supply  schedule  which  is  effective  at  any  one  moment.  Later  we  shall 
have  to  do  with  long-time  or  normal  schedules,  covering  a  whole  period  of 
some  length.  To  these  latter  schedules,  the  principle  just  laid  down  is  not 
always  applicable.  In  one  set  of  cases,  the  supply  may  be  equivalent  to 
the  whole  stock  and,  therefore,  does  not  vary  at  all.  In  another  set,  the 
supply  is  a  potential  output,  which  may  be  indefinitely  large,  provided  cost 


272 


PRINCIPLES  OF  ECONOMICS 


[XXI 


III 
The  Interpretation  of  Supply  Schedules 

Supply  Schedules  Composite. — The  first  point  to  be  noted 
in  the  interpretation  of  supply  schedules  exactly  corresponds  to  the 
first  one  noted  under  demand  schedules.  The  supply  at  any  par- 
ticular price  is  a  composite,  made  up  of  many  different  portions, 
each  one  of  which,  save  the  last,  would  appear  at  some  other  price, 
in  this  case,  a  lower  one.  Thus,  the  supply  at  60  cents,  170,000 
ounces,  consists  of  the  10,000  which  comes  on  the  market  when,  and 
because,  price  advances  from  59  cents  to  60  cents,  added  to  the 


40 


120 


160 


- 

_ 

a 

b 

c 

d 

e 

f 

g 

h 

i 

i 

k 

1 

m 

n 

o    p    q 

v, 

ri 

f 

h 

j 

i 

k 

1 

m 

n 

o  ~pl 

55 

w      FJ 

__ 

a 

b 

c 

d 

e 

f 

g 

h 

i 

j 

k 

1 

m 

n 

O 



a 

b 

c 

d 

e 

f 

g 

h 

i 

j 

k 

1 

m 

n 

— 

a 

b 

c 

d 

e 

f 

g 

h 

i 

j 

k 

1 

m 

— 

a 

b 

c 

d 

e 

f 

g 

h 

i 

j 

k 

1 

H 

h 

e 

A 

p 

f 

tr 

h 

i 

i 

k 

Figure  2.    Supply  Schedule  Composite 

160,000  already  offered  when  the  price  was  only  59  cents;  this 
160,000,  in  turn,  consists  of  the  10,000  which  comes  in  when,  and 
because,  price  rises  from  58  cents  to  59  cents  added  to  the  150,000 
already  offered  at  58  cents;  this  150,000,  again,  is  the  10,000  com- 
ing in  at  58  cents  added  to  the  140,000  already  offered  at  57  cents; 
and  so  on.  The  facts  are  illustrated  in  Figure  2,  where  the  little 
squares  marked  with  small  letters  show  the  increment  which  supply 


of  production  is  covered;  and,  hence,  the  schedule  shows  no  supply  at  prices 
below  the  one  covering  cost  and  an  indefinitely  large  supply  at  that  cost  price 
and  others  above  it.  But  these  points  will  be  more  fully  presented  later. 


XXI] 


273 


receives  in  each  instance  as  price  rises  to  the  level  indicated.  Thus, 
in  the  case  of  the  6o-cent  rectangle,  the  last  increment,  q,  appeared 
first  when  the  6o-cent  price  itself  was  reached;  p  came  up  from 
59  cents ;  o  from  58  cents ;  n  from  57  cents ;  m  from  56  cents ;  and 
so  on. 

Different     Increments. — With     supply,     as     with     demand 
schedules,  a  second  very  important  task  is  to  distinguish  the  differ- 


40 


80 


120 


160 


60- 


55 — 


I I 


I I 


I      I      I 


Figure  3.     Increments  of  Supply   Schedule   Classified — A 

ent  divisions  into  which  the  different  sections  or  increments  group 
themselves  just  as  soon  as  any  particular  price  is  established.  The 
principal  grouping,  as  before,  is  into  included  and  excluded  portions. 
Supposing  actual  price  to  be  55  cents,  all  possible  increments  of 
supply  which  are  conditioned  on  a  price  of  55  cents  or  anything 
lower,  will  be  included  increments;  while  all  possible  increments  of 


274  PRINCIPLES  OF  ECONOMICS  [XXI 

supply  which  are  conditioned  on  a  price  of  56  cents  or  anything  higher, 
will  be  excluded  increments.  Again,  among  the  included  increments, 
the  most  important  is  the  marginal  one,  the  one  which  is  the  last  to 
come  in  when  a  particular  price  is  being  established.  As  in  the  case 
of  demand,  we  should  note  that  the  marginal  increment  is  the  last 
to  come  in,  logically  not  chronologically.  That  is,  it  is  the  one  which 
the  conditions  present  would  be  expected  to  bring  in  last.  So,  again, 
another  effective  way  of  conceiving  this  increment  is  to  think  of 
it  as  the  increment  of  supply  which  would  be  the  first  to  drop  out 
if  actual  price  should  fall.  As  in  the  case  of  demand,  the  included 
increments  other  than  the  marginal  one  are  designated  infra-marginal 
increments;  and  all  the  excluded  ones,  extra-marginal  increments. 
The  location  of  these  various  sections  of  supply  is  plainly  indicated 
in  Figure  3. 

Different  Supply  Prices. — We  have  seen  that,  in  our  example, 

if   actual  price  was   55   cents,   the  marginal   increment   of   supply 

would  be  the  10,000  ounces  coming  in  at  55  cents.     It  hardly  need 

be  said  that  this  55  cents  would  constitute  the 

ry*  »•'»-' 

marginal  supply  price,  meaning  of  course  the 

PRICE  SUPPLY     prjce  which  is  necessary  to  bring  out,  and  will 

CENTS  ooo  oz.      £  .  * 

62  no        bring  out,  the  marginal  increment   of  supply. 

Similarly,   the  prices   bringing   out   the   intra- 

59  80        marginal  increments  of  supply   would  be  the 

intra-marginal  supply  prices,  while  the  prices 

56  80        which  would  bring  out  the  extra-marginal  in- 

&J        crements  of  supply  would  be  the  extra-marginal 

53  70        supply  prices.    Of  these  last,  as  in  the  case  of 

fcj       demand  prices,  only  one  is  of  importance,  that 

is  the  first  extra-marginal  supply  price. 

As  in  the  case  of  demand,  the  easiest  way  to  master  the  dis- 
tinction between  these  various  supply  prices  is  to  study  a  supply 
schedule  in  which  supply  remains  constant  for  several  steps.  A 
schedule  of  this  sort  is  represented  in  Table  2,  and  diagrammatically 
in  Figure  4, — supply  remaining  at  80,000  ounces  while  actual  price 
ranges  from  54  cents  up  to  59  cents.  Under  this  schedule  there  is 
a  sharp  separation  between  the  actual  price,  the  marginal  supply 


XXI] 


MARKET  SUPPLY  SCHEDULES 


275 


price,  and  the  first  extra-marginal   supply  price.     If  actual  price 

were  56  cents,  the  marginal  supply  price  would  be  54  cents  —  the 

price  which  brought  in  the  last  increment  of  supply  —  and  the  first 

extra-marginal  supply  price  would  be  60  cents  —  the  price  necessary 

to  bring  in  any  extra-marginal  increment  of  supply.     Moreover,  the 

marginal  supply  price  would  continue  to  be  54  cents,  and  the  first 

extra  -  marginal 

supply     price 

would     continue 

to  be  60  cents, 

so  long  as  actual 

price     was     not 

lower     than     54      60  — 

cents  nor  higher 

than  59  cents. 


» 

I    I    I    I    I    I    I 


55 — 


Marginal 
Supply  Price 
Highest.  --In 
our  analysis  of 
demand  sched- 
ules, it  was 
brought  out  that 
the  marginal  in- 
crement of  de- 
mand is  the  one 
coming  in  at  the 
lowest  of  the 

prices  at  which  any  comes  in ;  and  so,  of  course,  the  marginal  de- 
mand price  is  the  lowest  of  those  prices  at  which  any  demand  comes 
in.  The  case  of  supply  exactly  reverses  this.  The  marginal  incre- 
ment of  supply  is  that  one  among  the  several  increments  which 
comes  in  at  the  highest  of  all  the  prices  at  which  any  supply  comes 
in ;  and,  so,  the  marginal  supply  price  is  the  highest  of  those  prices 
at  which  any  supply  comes  in. 

Manifestly,   similar   antitheses   appear    in   connection    with   the 
other    significant    prices.      The    intra-iuurginal    demand   prices   are 


50 — 


Figure  4.  Increments  of  Supply  Schedule  Classified — B 


276  PRINCIPLES  OF  ECONOMICS  [XXI 

higher  than  the  marginal  one;  the  mtra-marginal  supply  prices  are 
lower  than  the  marginal  one.  On  the  other  hand,  the  extra-marginal 
demand  prices  are  loiver  than  the  marginal  one ;  the  extra-marginal 
supply  prices  are  higher  than  the  marginal  one. 

It  is  hardly  necessary  to  add  that  we  often  have  occasion  to  apply 
the  terms  marginal  and  extra-marginal  to  sellers.  Marginal  sellers 
are  those  who  offer  to  sell  some  or  all  of  their  offerings  only  when, 
and  because,  actual  price  has  risen  to  the  marginal  supply  price. 
In  other  words,  marginal  sellers  are  the  ones  responsible  for  the 
marginal  increments  of  supply.  Their  offerings  would  not  be  made, 
if  price  were  lowered.  Extra-marginal  sellers  are  those  responsible 
for  the  extra-marginal  increments  of  supply.  They,  of  course, 
make  no  sales  and  are  commonly  referred  to  as  excluded  sellers. 

ILLUSTRATIVE  PROBLEMS 

i.  Suppose  the  conditions  of  supply  of  Milton's  autographs  to  be 
such  that  15  would  be  offered  if  the  price  were  $200;  13,  if  it  were  $175; 

12,  if  $150;  9,  if  $140;  8,  if  $125;  5,  if  $110;  4, 
PRICE  SUPPLY     if  $IOO    2   if  $        and       if  $? 

CENTS  ooo  oz.          v,     '    '  ;/0  . 

68  163  (a)     Make  out  this  supply  schedule  in  tabular 

67  150         form. 

(b)     Make  out  a  combined  demand  and  sup- 

64  135         Pty   schedule   using   a   demand   schedule   of   your 

63  120         own. 

62  120 

61  120  2.     Suppose  the  supply  schedule  for  cordwood 

60  112  on  a  certain  Saturday  to  be  as  follows:   I   cord 

Q  J££  offered  if  price  is  $4.50;  2,  if  price  is  $4.75;  two 

04  more,   if  $5;  three  more,   if  $5.25;   10  in  all,  if 

96  85  $5.50;  17,  if  $5.75;  and  8  more,  if  $6. 

«£  Make  out  a  combined  demand  and  supply  sched- 

72  ule   for  this   wood  using  a  demand   schedule  of 

52  72  your  own. 

3.     Suppose  that  the  supply  schedule  for  silver 

at  a  certain  date  is  represented  by  the  accompanying  table,  and  answer 
the  questions  which  follow: 

(a)  Interpret  the  last  five  lines,  beginning  at  tbe  last;  also  the  tenth 
to  the  fifth. ' 

(b)  What  would  be  the  marginal  increment  of  supply  if  actual  price 
were  55  cents?    60  cents?    63  cents?     58  cents?     52  cents?    65  cents? 


XXI]  MARKET  SUPPLY  SCHEDULES  277 

(c)  What  would  be  the  first  extra-marginal  increment  of  supply  if 
actual  price  were  54  cents  ?     56  cents  ?     59  cents  ?    64  cents  ?    67  cents  ? 

(d)  What  would  be  the  marginal  supply  price  if  actual  price  were 
67  cents  ?    65  cents  ?     63  cents  ?    62  cents  ?     59  cents  ?     55  cents  ? 

(e)  What  would  be  the  first  extra-marginal  supply  price  if  actual 
price  were  66  cents?     63  cents?    61  cents?     59  cents?     55  cents?     52 
cents  ? 

(f )  Who  would  be  the  marginal  sellers  if  actual  price  were  67  cents? 
64  cents  ?     63  cents  ?     59  cents  ?     56  cents  ?     54  cents  ? 

(g)  Who  would  be  the  first  extra-marginal  sellers  if  actual  price  were 
66  cents?    61  cents?     59  cents?     58  cents?     55  cents?     52  cents? 

4.  "In  the  case  of  a  large  majority  of  commodities,  profits  do  not 
form  a  part  of  the  marginal  supply  price.    For,  in  almost  every  industry, 
the  marginal  producers,  the  ones  whose  costs  determine  the  marginal  sup- 
ply price,  are  getting  no  profit  at  all — in  many  cases  are  taking  losses.    I 
have  in  mind  producers  who  are  way  behind  the  times  in  the  methods 
they  employ  and  hence  are  producing  at  the  greatest  cost  of  all  producers 
in  their  line,  but  who  are  bound  to  stay  on  producing  until  they  are  bank- 
rupt just  because  they  have  no  other  way  of  making  even  a  semblance 
of  a  living." 

Answer :  "The  producers  described  are  intra-marginal,  not  marginal, 
producers."  Defend  the  last  statement. 

5.  Mr.  A  produces  a  certain  commodity  at  an  actual  outlay  of  12 
cents  per  unit,  while  the  outlay  of  another  producer,  Mr.  B,  is  15  cents; 
yet  Mr.  A  may  be  producing  the  marginal  increment  of  supply.     How 
could  that  be  true? 

6.  "One  of  the  most  exasperating  things  in  the  lot  of  the  laboring 
man  is  the  fact  that,  however  high-minded  he  may  be,  however  anxious 
to  get  wages  which  insure  himself  and  his  family  a  decent  living,  his 
actual  wages  are  bound  to  be  fixed  by  the  rate  which  the  meanest-spirited 
of  his  fellow  workmen  stand  ready  to  take." 

Supposing  that  wages  were  fixed  by  the  attitude  of  laborers  only, 
that  is,  by  the  amount  which  they  stand  ready  to  take,  show  that  the  par- 
ticular laborer  performing  this  function  would  not  be  the  meanest-spirited 
one. 


CHAPTER  XXII 

PRINCIPLES  GOVERNING  THE  IMMEDIATE 
PROCESSES  OF  PRICE  DETERMINATION 

In  order  to  make  an  adequate  study  of  price,  it  seems  almost 
indispensable  to  attack  that  problem  at  successive  levels,  in  other 
words,  with  successive  degrees  of  thoroughness.  We  shall  begin, 
therefore,  by  trying  to  settle  the  more  superficial  phases  of  the 
problem ;  follow  this  with  a  solution  somewhat  more  thorough ;  and 
finish  with  an  attempt  to  penetrate  the  whole  matter  to  the  bot- 
tom. Our  study  will  thus  break  roughly  into  three  parts:  (i)  the 
immediate  processes  of  price  determination, — market  price,  (2)  the 
intermediate  processes, — normal  price,  and  (3)  the  ultimate  processes. 
All  such  divisions  are  of  course  more  or  less  arbitrary,  but  the 
one  used  will,  I  believe,  justify  itself  as  we  proceed.  The  present 
chapter,  then,  is  concerned  with  the  immediate  processes  of  price 
determination. 

I 

The  Law  of  Single  Price 

From  the  facts  of  demand  and  supply  presented  in  the  last 
chapter,  the  student  might  naturally  expect  to  find  the  same  com- 
modity selling  for  several  different  prices.  The  appearance  of  a 
particular  portion  of  demand,  we  learned,  is  conditioned  on  the 
establishment  of  one  particular  price,  the  appearance  of  another 
portion  on  the  establishment  of  another  price,  and  so  on;  and  an 
exactly  similar  statement  is  true  for  supply.  At  almost  any  price, 
then,  buyers  could  find  someone  ready  to  sell,  and  sellers  could  find 
someone  ready  to  buy.  Even  if  the  forces  we  are  about  to  study 
seemed  likely  to  set  up  a  certain  price,  say  55  cents  in  our  silver 
problem,  why  is  it  not  reasonable  to  expect  that  sales  would  after 
all  be  made  at  both  higher  and  lower  prices? 

278 


XXII]  IMMEDIATE  PRICE  DETERMINATION  279 

Under  some  circumstances,  this  would  undoubtedly  prove  to  be 
the  case.  If  several  buyers  with  different  notions  as  to  what  they 
wish  to  pay,  go  to  as  many  different  sellers,  and,  without  inquiring 
of  more  than  one  seller  make  their  purchases,  some  will  certainly 
pay  more  and  some  less  for  the  same  commodity.  The  reason  is 
that  each  buyer  is  unaware  of  the  offerings  of  sellers  other  than 
the  one  he  has  visited.  Similarly,  if  various  sellers  are  dealing  each 
with  an  isolated  customer,  some  will  get  larger  prices  and  some 
will  accept  smaller,  because  each  is  unaware  of  what  other  customers 
might  be  willing  to  pay.  Even  in  the  same  trading  room  it  some- 
times happens  that  the  noise,  crowding,  and  excitement  so  operate 
as  practically  to  separate  the  sellers  and  buyers  into  different  groups, 
making  sellers  in  one  part  of  the  room  unaware  of  what  buyers 
in  another  part  will  pay,  and  buyers  in  one  part  unaware  of  what 
sellers  in  another  part  will  take.  Here  also,  therefore,  some  buyers 
will  pay  more  than  they  would  really  need  to  if  they  looked  about 
them  a  little,  and  some  sellers  will  accept  less. 

But  the  cause  of  these  variations  is  plainly  something  abnormal. 
The  market  described  is  not  even  approximately  the  perfect  market 
which  our  study  postulates.  Full  competition  between  the  different 
sellers  on  the  one  side  and  the  different  buyers  on  the  other  is  not 
realized.  Some  of  the  sellers  do  not  have  a  chance  to  provide  every 
buyer  with  an  opportunity  to  purchase  from  them.  Some  of  the 
buyers  do  not  have  a  chance  to  provide  every  seller  with  an  oppor- 
tunity to  make  a  sale  to  them.  If  all  sellers  and  all  buyers  did  so 
provide,  the  result  would  be  very  different.  No  buyer  would  pay 
more  than  any  other,  because  other  sellers,  desiring  to  get  his  custom, 
would  underbid  the  seller  about  to  receive  the  exceptionally  high 
price, — would,  so  to  speak,  -force  the  buyer  to  take  their  wares 
at  the  lower  price.  Neither  would  any  seller  accept  less  than  any 
other,  because  buyers  other  than  the  one  about  to  get  the  commodity 
at  the  lower  price  would  promptly  overbid  that  one, — would,  so 
to  speak,  force  the  seller  to  take  a  higher  price.  In  a  market  which 
is  truly  single  and  theoretically  perfect,  therefore,  any  commodity 
at  any  one  time  must  be  selling  at  a  single  price. 

In  the  real  world,  of  course,  there  are  no  theoretically  perfect 
markets.  The  great  exchanges  for  wheat,  cotton,  and  steel  where 


280  PRINCIPLES  OF  ECONOMICS  [XXII 

many  buyers  and  sellers  actually  meet  in  the  same  room  and  where 
almost  every  conceivable  means  is  available  for  informing  one's  self 
of  the  facts,  doubtless  at  times  approach  perfection ;  but  ignorance, 
folly  and  the  failure  of  competition  always  prevent  the  condition 
from  being  reached ;  and  in  ordinary  markets,  naturally,  this  is  much 
more  emphatically  true.  Nevertheless,  the  tendency  toward  a  single 
price  set  up  by  the  forces  mentioned  above  is  always  sufficiently 
strong  to  be  of  real  and  practical  significance.  Even  in  the  retail 
trade,  differences  between  the  prices  of  the  same  commodity  in  the 
same  market  or  in  connected  markets  are  at  once  recognized  as  ab- 
normal. The  smallest  differences  are  remarked  upon ;  anything 
like  an  indefinite  enlargement  is  quite  impossible ;  and  with  the  spread 
of  greater  knowledge,  alertness,  and  skill  among  buyers  and  sellers 
they  must  tend  rapidly  to  diminish  and  disappear. 

Summarizing  the  above  discussion,  we  have  the  following  prin- 
ciple : 

Principle — The  Law  of  Single  Price. 

Within  the  limits  of  a  truly  single  and  theoretically  per- 
fect market,  no  commodity  can  have  more  than  one  price 
at  the  same  time;  and  even  within  the  limits  of  imperfect 
markets  or  groups  of  connecting  markets,  any  commodity 
must  tend  to  have  a  single  price, — allowance  being  made  in 
the  latter  case  for  the  expense  of  shifting  from  one  to  an- 
other of  the  connecting  markets. 

Corollary  i. — The  law  of  single  price  secures  to  many 
consumers  a  differential  advantage  known  as  buyer's  sur- 
plus, i.  c.,  a  quantity  of  other  commodities  which  they  can 
enjoy  because  of  the  fact  that  they  can  secure  the  one  under 
consideration  at  a  lower  price  than  the  price  which  they 
would  be  willing  to  give,  even  for  the  marginal  unit. 

Corollary  2. — The  law  of  single  price  secures  to  owners 
of  some  scarce  and  exceptionally  efficient  factor  in  produc- 
tion a  differential  gain.  In  the  case  of  land,  this  is  called 
rent;  elsewhere,  a  quasi-rent. 


XXII]  IMMEDIATE  PRICE  DETERMINATION  28l 

II 
The  Law  of  Supply  and  Demand 

We  are  now  prepared  to  explain  the  actual  processes  of  price- 
determination  through  what  is  commonly  known  as  the  law  of 
supply  and  demand.  In  doing  this,  we  shall  deal  with  demand  and 
supply  schedules  of  the  regular,  symmetrical  sort  which  we  have 
called  typical,  though  it  will  be  necessary  later  to  note  some  varia- 
tions from  these.  Let  us  begin  by  placing  before  ourselves,  in 
both  tabular  and  diagrammatic  form,  our  typical  demand  and  supply 
schedules  combined  into  one.  In  the  table, 

the  common  price  is  placed  in  the  middle     DEMAND    PRICE    SUPPLY 
column,  while  the  demands  corresponding      °°^0OZ-    CE^TS    °^^z- 
to  the  several  prices  appear  in  the  first  col-         80          59           160 
umn,  and  the  supplies  in  the  third.     The        ^ 
diagram  in  the  figure  on  page  284  repre-        no          56          130 
sents  the  supply  rectangles  superposed  on  ™° 

those  of  demand  in  such  a  way  that  the        140          53  100 

boundaries  of  the  rectangles  which  express        ^          j?^  g£ 

demand   and   supply,    respectively,    at    any        17°          5°  7° 

particular  price,   coincide   as    far  as   their 

length  will  permit.  Since  the  demand  rectangles  are  shaded  from 
left  to  right  downward,  while  the  supply  rectangles  are  shaded  from 
left  to  right  upward,  the  portions  which  coincide  are  cross-shaded, 
while  the  parts  not  coincident  have  only  the  parallel  shading. 

Some  Price  Equates  Supply  and  Demand. — From  all  the 
data  now  before  us,  it  is  easy  to  derive  a  series  of  propositions  em- 
bodying the  most  important  facts  of  immediate  price-determina- 
tion. First,  from  the  very  nature  of  demand  and  supply  schedules, 
there  is  bound  to  be,  generally  speaking,  one  price  at  which  demand 
and  supply  arc  equal.  This  obviously  grows  out  of  the  fact  that 
changes  in  price  affect  demand  and  supply  in  precisely  opposite 
ways :  demand  varies  inversely  as  price ;  supply  varies  directly  as 
price.  Two  quantities  moving  in  opposite  directions  under  the 
influence  of  the  same  cause  are  bound  to  coincide  at  some  point. 


282  PRINCIPLES  OF  ECONOMICS  [XXII 

This  is  illustrated  in  the  figure,  in  which  the  rectangles  representing 
demand  and  supply  coincide  throughout  their  length  at  a  price 
of  55  cents. 

Seeming  Exception. — A  seeming  exception  to  the  above 
statement  might  indeed  be  found.  That  is,  we  might  have  so  con- 
structed our  schedules  that,  at  a  price  of  55  cents,  supply  would  have 
been  greater  than  demand;  while,  at  54  cents,  demand  would  have 
been  greater  than  supply.1  This  exception,  however,  is  only  a  seem- 
ing one.  Under  the  conditions  supposed,  the  unit  of  price  variation 
used  is  too  large  for  actual  market  conditions.  Making  that  unit  a 
half  cent,  instead  of  a  whole  one,  would  probably  bring  out  a  coin- 
cident price;  for  a  fall  in  price  from  55  to  54^  cents,  though  in- 
creasing demand,  would  not  increase  it  to  the  120,000  which  54 
cents  would  bring  out ;  while  that  same  fall  to  54^2  cents,  though 
cutting  down  supply,  would  not  cut  it  down  to  110,000.  In  fact 
it  is  highly  probable  that,  if  our  schedules  had  used  this  smaller 
money  unit,  demand  and  supply  at  this  new  price  of  54^2  cents 
would  each  have  been  just  115,000,  and  so  the  equality  required 
would  have  been  reached.  If  not,  still  further  subdivision  of  the 
unit  would  have  been  made,  until  one  would  appear  fulfilling  the 
condition  affirmed  as  necessary,  that  is,  bringing  demand  and  supply 
to  equality. 

We  have  seen  that,  from  the  very  nature  of  demand  and  supply 
schedules,  there  is  bound  to  be  a  price  at  which  demand  and  supply 
are  equal. 

It  is  equally  evident  that,  in  the  case  of  what  we  have  called  typi- 
cal schedules,  any  price  higher  than  the  equating  one  is  bound  to 
show  a  supply  in  excess  of  demand,  zt'hile  any  lower  price  is  bound 
to  show  a  demand  in  excess  of  supply.  This,  again,  grows  out  of 
the  very  nature  of  demand  and  supply  schedules.  As  price  rises, 
demand  falls  off  while  supply  increases,  thus  making  the  latter  ex- 
cessive. As  price  falls,  demand  increases  while  supply  falls  off,  thus 
making  the  former  excessive. 


1  Leave  the  supply  schedule  as  before,  but  make  the  demand  schedule  read : 
60,000  at  60  cents ;  70,000  at  59  cents ;  80,000  at  58  cents ;  and  so  on. 


XXII]  IMMEDIATE  PRICE  DETERMINATION  283 

Sellers  and  Excess  of  Supply. — A  third  proposition  which  is 
easily  established  affirms  that  any  price  at  which  supply  is  in  excess 
of  demand  is  bound  to  be  replaced  by  a  lower  price  through  the 
competition  of  sellers:  any  price  higher  than  the  one  which  equal- 
izes demand  and  supply  is  bound  to  be  eliminated.  This  grows  out 
of  the  fact  that  it  is  to  the  interest  of  all  sellers  who  wish  to  make 
sales  at  or  below  the  price  which  equalizes  demand  and  supply  to 
use  every  means  in  their  power  to  change  a  condition  which  shows 
supply  in  excess,  in  other  words,  to  destroy  that  excess.  The  reason 
for  this  is  that,  as  long  as  such  an  excess  of  supply  over  demand  is 
present,  there  is  danger  that  said  sellers,  though  willing  to  sell  at 
a  lower  price  will  not,  after  all,  be  able  to  sell  at  all ; — some  seller 
who  would  come  in  only  if  the  higher  price  was  reached,  may  have 
the  luck  to  make  sales  before  the  more  willing  sellers  do,  so  that 
when  the  latter  appear,  buyers  will  already  have  been  satisfied. 
But  not  only  have  the  more  eager  sellers  motives  for  using  every 
means  to  eliminate  the  excess  of  supply,  they  have  the  power  to  do 
so.  First,  they  are  willing  and  so  can  afford  to  offer  the  goods  at 
a  lower  price.  Secondly,  this  lowering  of  the  price  would  reduce 
the  excess  of  supply  over  demand — reduce  the  discrepancy  between 
supply  and  demand, — in  two  ways :  ( i )  it  would  increase  the  de- 
mand, (2)  it  would  diminish  the  supply. 

This  is  plainly  seen  from  the  accompanying  demand  and  supply 
schedule  for  silver.  Sellers  ready  to  dispose  of  the  metal  at  a  price 
of  55  cents  cannot  afford  to  permit  a  price  higher  than  this,  even 
if  only  one  cent  higher,  56  cents.  For,  since  at  56  cents  demand 
is  10,000  ounces  smaller  and  supply  10,000  ounces  larger,  supply  at 
this  figure  shows  an  excess  over  demand  of  20,000  ounces,  so  that 
some  sellers  willing  to  supply  silver  at  55  cents  or  less  may  fail  to 
sell  at  all.  But,  by  bidding  price  down  to  55  cents,  they  insure  selling 
their  whole  supply;  since  they  increase  demand  by  10,000  and 
diminish  supply  by  an  equal  amount,  and  so  make  demand  just 
equal  to  supply  at  120,000  ounces. 

This  reasoning  is  diagrammatically  illustrated  in  the  accompany- 
ing figure.  At  55  cents  the  rectangles  of  demand  and  supply  precisely 
coincide  at  120,000  ounces.  At  56  cents,  however,  supply  shows  an 
excess  represented  by  the  portion  of  this  rectangle  having  only  the 


284 


PRINCIPLES  OF  ECONOMICS 


[XXII 


parallel  shading.  Again,  this  excess  rectangle  is  divided  into  two 
equal  squares  by  the  dotted  vertical.  Of  these  two  squares,  the  left 
one  represents  that  portion  of  the  discrepancy  between  demand  and 
supply  due  to  the  falling  off  of  demand,  while  the  right  square  repre- 
sents the  portion  of  the  discrepancy  due  to  the  fact  that  with  the 
rising  price  supply  increases.  When  sellers  bring  down  the  price  to 

80  120  If 


40 


60- 


55- 


50" 


I      I      I 


I      I      I 


I      I      I 


Price  Equating  Supply  and  Demand 


55  cents,  the  first  portion  of  the  discrepancy  is  eliminated  by  the  in- 
crease of  demand  as  shown  in  the  square  at  the  right  end  of  the 
55-cent  rectangle  cut  off  by  the  dotted  vertical,  and  the  second  portion 
is  eliminated  by  the  decrease  in  supply  shown  by  the  disappearance 
of  the  square  which  appeared  at  the  right  end  of  the  56-cent 
rectangle. 

Buyers  and  Excess  of  Demand. — We  have  seen  that  any 
price  higher  than  the  one  which  equalizes  supply  and  demand  is 
bound  to  be  shut  out  by  the  competition  of  sellers.  Analogous 


XXII]  IMMEDIATE  PRICE  DETERMINATION  285 

reasoning  easily  shows  that  any  price  lower  than  the  one  which 
equalises  supply  and  demand  is  bound  to  be  shut  out  by  the  com- 
petition of  buyers.  All  such  lower  prices  must  cause  demand  to  be 
in  excess  of  supply.  But  buyers  willing  to  pay  a  price  as  high  as 
the  equalizing  one  cannot  afford  to  let  demand  remain  in  excess, 
lest  the  lower-price  buyers  should  take  off  a  part  of  the  supply  and 
leave  them  in  the  lurch.  They — the  higher-priced  buyers — will 
therefore  bid  up  the  price ;  and  this  process  will  eliminate  the  excess 
of  demand  and  that  for  two  reasons  as  before:  (i)  the  higher  price 
will  increase  supply  and  (2)  the  higher  price  will  diminish  demand. 
In  the  diagram  these  two  sources  of  the  discrepancy  between  de- 
mand and  supply  are  represented  in  the  54-cent  rectangle  by  the 
two  divisions  of  the  single-shaded  portion  divided  by  the  dotted 
line.  The  left  represents  the  falling-off  in  supply;  the  right  repre- 
sents the  increase  in  demand.  When  the  actual  price  is  bid  up  to 
55  cents,  the  increase  in  supply  at  once  takes  place,  as  indicated  by 
the  cross  shading  of  the  square  at  the  right  end  of  the  rectangle; 
on  the  other  hand,  a  decrease  of  demand  takes  place,  as  represented 
by  the  blank  at  the  end  of  the  55-cent  rectangle  which  takes  the  place 
of  the  last  shaded  square  in  the  54-cent  rectangle. 

It  is  obviously  implicit  in  the  points  made  in  the  last  few  para- 
graphs, the  points  namely:  that  actual  price  cannot  be  either  higher 
or  lower  than  that  price  which  equalizes  demand  and  supply,  that 
actual  price  cannot  be  different  from  said  equalizing  price.  Equi- 
librium among  the  price-making  forces  could  not  be  established  as 
long  as  a  price  other  than  the  equalizing  one  prevailed. 

There  still  remains  the  question  whether  even  that  equalizing 
price  could  prevail.  Would  it  secure  equilibrium  among  the  price- 
making  forces  and  therefore  stand?  Our  answer  must  be  in  the 
affirmative.  The  price-making  forces  which  are  supposed  to  be 
operative  in  our  problem  are  those  which  grow  out  of  the  competi- 
tion of  sellers  on  the  one  hand  and  that  of  buyers  on  the  other. 
These  forces  consist  of  that  fact  about  the  self-interest  of  sellers 
which  leads  them  to  underbid  other  sellers  in  order  to  insure  getting 
a  market,  and  that  fact  about  the  self-interest  of  buyers  which  leads 
them  to  overbid  other  buyers  in  order  to  insure  getting  the  supply 
they  desire.  But  just  as  soon  as  a  price  has  been  reached  which 


286  PRINCIPLES  OF  ECONOMICS  [XXII 

equalizes  demand  and  supply,  these  forces  become  quiescent ;  neither 
sellers  nor  buyers  need  to  do  anything  in  order  to  accomplish  their 
ends.  At  a  price  of  55  cents,  included  sellers  will  market  all  their 
wares,  included  buyers  will  make  all  the  purchases  they  desire  to. 
At  this  point,  therefore,  there  is  no  disturbing  condition  left,  there 
is  no  force  derived  from  competition  which  tends  either  to  lower 
price  or  to  raise  it.  This  price,  therefore,  tends  to  secure  equi- 
librium among  the  price-making  forces.  No  other  can  prevail ; 
this  one  can.  Accordingly,  it  is  the  price  which  tends  to  be  estab- 
lished. 

Law  of  Supply  and  Demand. — We  will  now  summarize  the 
preceding  discussion  in  a  formula  which  contains  the  most  essential 
elements  of  what  is  commonly  called  the  Law  of  Supply  and 
Demand. 

Principle — The  Law  of  Supply  and  Demand. 

Given  a  typical  demand  and  supply  schedule,  price  must 
tend  to  rise  so  long  as  demand  is  in  excess  of  supply  and 
to  fall  so  long  as  supply  is  in  excess  of  demand;  it  must 
therefore  move  up  or  down  till  it  reaches  a  figure  which 
equates  supply  and  demand;  and  at  this  point  it  can  rest, 
since  here  the  price-moving  forces  become  quiescent. 

The  principle  just  set  forth  covers  the  main  part  of  what  is 
really  essential  in  the  law  of  supply  and  demand.  Other  significant 
points  are  little  more  than  corollaries  of  this.  One  of  the  first  of 
these  concerns  the  effect  on  price  of  changes  in  either  supply  or 
demand, — meaning,  remember,  changes  in  the  schedules,  the  different 
supplies  or  demands  at  a  series  of  prices.  As  respects  supply,  the 
answer  is  contained  in  the  following  corollary : 

Corollary  i.  A  rise  or  fall  in  the  supply  schedule 
tends  to  bring  about  an  opposite  (not  proportional}  change 
in  price. 

A  glance  at  the  facts  will  show  this  conclusion  to  be  inevitable. 
A  rise  in  the  supply  schedule  means  that  supply  is  now  in  excess 


XXII]  IMMEDIATE  PRICE  DETERMINATION  287 

at  the  going  price.  But  the  principle  tells  us  that  price  must  tend  to 
fall  so  long  as  supply  is  in  excess  of  demand.  The  rise  in  supply 
must  therefore  tend  to  bring  about  a  fall  in  price,  that  is,  an  opposite 
change.  On  the  other  hand,  if  the  supply  schedule  declines  in 
volume,  demand  at  the  going  price,  the  price  which  made  supply  and 
demand  equal,  will  be  in  excess  of  supply.  But  the  principle  tells 
us  that  price  must  tend  to  rise  so  long  as  demand  is  in  excess  of 
supply.  A  decline  in  the  supply  schedule  must,  therefore,  tend 
to  bring  about  a  rise  in  price,  an  opposite  change. 

Corollary  2.  A  rise  or  fall  in  the  demand  schedule 
tends  to  bring  about  a  like  (not  proportional}  change  in 

price. 

The  argument  is  similar  to  that  employed  for  the  corollary  above. 
A  rise  in  the  demand  schedule  makes  demand  at  the  going  price  in 
excess  of  supply;  under  the  principle,  therefore,  it  tends  to  cause 
a  rise  in  price,  which  constitutes  a  like  change.  A  fall  in  the  de- 
mand schedule  makes  supply  at  the  going  price  in  excess  of  demand ; 
and  this,  under  the  principle,  tends  to  bring  about  a  lower  price, 
which  is  also  a  like  change. 

Corollary  3.  A  commodity,  the  schedule  of  which 
shows  a  higher  ratio  of  demand  over  supply  at  a  given 
price  than  the  schedule  of  another  commodity  shows  at  the 
same  price,  will  usually  show  a  higher  actual  price  also. 

Thus,  if  at  a  price  of  51  cents,  the  ratio  of  the  demand  for  silver 
over  the  supply  is  2  to  i,  while  that  of  copper  is  2  to  3,  the  price 
of  silver  will  naturally  be  higher  than  that  of  copper.  The  price 
of  silver  would  have  to  move  up  to  equate  supply  and  demand; 
while  that  of  copper  would  have  to  move  down.  This  corollary 
emphasizes  the  point  which  the  business  world  somewhat  inexactly 
expresses  in  saying  that  "price  is  all  a  matter  of  the  ratio  between 
supply  and  demand."  Its  importance  lies  in  the  explanation  it  pro- 
vides of  the  great,  and  often  very  trying,  differences  in  the  prices 
of  things,  and  especially  in  the  remuneration  obtainable  for  supplying 
different  types  of  services. 


288  PRINCIPLES  OF  ECONOMICS  [XXII 

ILLUSTRATIVE  PROBLEMS 

1.  "On  the  Black  Friday  of  1869,  gold  was  sold  on  one  side  of  the 
room  for  $1.60  when  it  was  being  sold  on  the  other  for  $1.35,  etc." — 
Sumner. 

(a)  Why  is  such  a  fact  noteworthy  from  the  economic  point  of 

view? 

(b)  How  was  it  to  be  explained,  do  you  suppose? 

2.  Professional  men,  especially  those  of  the  medical  profession,  fre- 
quently try  to  eliminate  the  law  of  single  price  in  respect  to  their  services. 

(a)  Why  is  it  for  the  interest  of  physicians  to  get  rid  of  this  law? 

(b)  Give  some  reason  why  they  are  quite  likely  to  have  more  or 
less  success  in  carrying  out  this  policy. 

3.  "The  price  cannot  long  remain  above  cost  of  production.     For,  so 
long  as  it  is  above,  profits  will  be  exceptionally  high ;  this  fact  will  cause 
production  to  increase;  as  a  result  supply  will  become  .  .  .  ,  and  price 
will  ..." 

Fill  in  the  blanks,  using  the  Law  of  Supply  and  Demand. 

4.  "The  demand  for  wheat  was  increased  beyond  the  capacity  of  the 
best  lands  to  furnish  it,  and  so  a  new  supply  was  brought  out  by  putting 
inferior  lands  under  cultivation." 

To  make  that  reasoning  quite  complete,  one  or  two  other  links  should 
have  been  put  in  between  the  premise  and  the  conclusion.  Supply  those 
links. 

5.  "Demand  having  increased,  price  rises.     But  this  higher  price  cuts 
down  demand;  and  so  price  comes  right  back  to  where  it  was  in  the 
first  place." 

Show  that  this  result  could  not  be  reached  in  a  normal  case. 

6.  The  high  rate  of  exchange  made  exporting  more  than  usually 
profitable.     As  a  result,  the  supply  of  cotton  for  the  foreign  market 
.  .  .,  the  price  .  .  .,  this  caused  the   foreign  demand  to  .  .  .,   and  so 
exports  .  .  . 

Fill  out  the  blanks,  applying  the  Law  of  Supply  and  Demand. 


CHAPTER  XXIII 

LIMITING  PRICES 

In  the  reasoning  employed  in  the  last  chapter  to  establish  the 
principle  of  supply  and  demand,  we  necessarily  touched  upon  some 
of  the  deeper  forces  and  processes  which  are  determining  prices  and 
bringing  them  under  the  rule  of  supply  and  demand.  We  will  now 
inspect  these  forces  a  little  more  closely.  In  particular,  we  will 
show  the  dependence  of  the  prices  actually  established  on  certain 
special  prices  among  the  different  demand  and  supply  prices.1 

The  method  which  we  employed  to  prove  that  the  one  price  at 
which  demand  and  supply  are  equal  must  prevail  was  to  show  that 
all  other  prices  are  certain  to  be  shut  out  by  the  competition  of  either 
buyers  or  sellers.  Actual  price,  we  saw,  must  not  go  above  55 
cents  lest  it  should  shut  out  the  marginal  buyers,  nor  up  to  56  cents 
lest  it  should  let  in  new  sellers ;  and,  on  the  other  hand,  it  must  not 
go  below  55  cents  lest  it  shut  out  the  marginal  sellers,  nor  down  to 
54  cents  lest  it  let  in  new  buyers.  Now,  if  these  same  facts  be 
interpreted  from  our  present  standpoint,  they  tell  us  that  the  upper 
limits  of  price  are  fixed,  or  may  be  fixed,  by  either  of  two  prices 
of  the  schedule,  and  that  the  lower  limits  are,  or  may  be,  fixed  by 
either  one  of  another  two  prices  of  the  schedule.  Let  us  now  define 
more  precisely  these  limiting  prices. 

Upper  Limits. — Price  could  not  go  above  55  cents  lest  it 
should  shut  out  the  marginal  buyers.  But  55  cents,  as  the  price 
which  brought  in  the  marginal  buyers,  is  the  marginal  demand  price. 
It  follows  that  actual  price  cannot  go  above  the  marginal  demand 
price,  that  is,  cannot  go  to  the  price  next  above  the  marginal  demand 
price.  Thus,  one  of  the  upper  limits  of  price  is  the  price  next  above 


1  In  later  connections,  we  shall  comment  on  various  facts  and  forces  lying 
behind  these  special  demand  and  supply  prices. 

28Q 


290  PRINCIPLES  OF  ECONOMICS  [XXIII 

the  marginal  demand  price.  Again,  price  could  not  go  up  to  56 
cents  because  this  would  let  in  new  sellers.  But  the  price  which 
will  let  in  new  sellers  we  have  already  defined  as  the  first  extra- 
marginal  supply  price.  Consequently,  actual  price  cannot  go  up  to 
the  first  extra-marginal  supply  price.2  Accordingly,  the  second  pos- 
sible upper  limit  of  price  is  the  first  extra-marginal  supply  price. 

Lower  Limits. — Turning  now  to  the  lower  limit,  price  could 
not  go  below  55  cents  lest  it  shut  out  the  marginal  sellers.  But 
55  cents,  as  the  price  which  brought  in  the  marginal  sellers,  is  the 
marginal  supply  price.  Actual  price,  therefore,  must  not  go  below 
the  marginal  supply  price,  that  is,  as  low  as  the  price  next  below  the 
marginal  supply  price.  Accordingly,  one  of  the  possible  lower  limits 
of  price  is  the  price  next  below  the  marginal  supply  price.  Finally, 
price  must  not  go  down  to  54  cents  because  that  figure  would  let  in 
new  buyers.  But  the  price  which  would  let  in  new  buyers  we  have 
already  designated  the  first  extra-marginal  demand  price.  Hence, 
actual  price  must  not  go  down  to  the  first  extra-marginal  demand 
price.  Thus,  a  second  possible  lower  limit  of  actual  price  is  the  first 
extra-marginal  demand  price.  We  thus  have  four  prices  which  act, 
or  may  act,  to  fix  the  limits  within  which  actual  price  must  be  estab- 
lished, namely:  the  marginal  demand  price,  the  first  extra-marginal 
supply  price,  the  marginal  supply  price,  and  the  first  extra-marginal 
demand  price.8 


1  In  one  important  case,  the  first  extra-marginal  supply  price  and  the 
marginal  supply  price  coincide.  This  happens  when  possible  output  at  a 
certain  cost  is  indefinitely  large :  producers  can  supply  much  more  than  is 
demanded  without  incurring  increased  costs.  In  that  case  we  cannot  say 
that  actual  price  must  not  go  up  to  the  first  extra-marginal  supply  price. 
It  must  do  so,  else  supply  will  not  be  adequate,  since  this  is  the  marginal, 
as  well  as  the  first  extra-marginal,  supply  price.  For  this  case,  we  have  to 
say  that  actual  price  cannot  go  beyond  the  first  extra-marginal  supply  price. 
The  competition  of  producers  who  stand  ready  to  supply  an  indefinite  amount 
at  this  figure  will  shut  out  any  higher  one.  Note,  however,  that  actual  price 
cannot  go  above  this  price,  not  because  it  is  the  marginal  supply  price,  but 
because  it  is  the  first  extra-marginal  supply  price,  because  it  is  the  price 
which  conditions  the  forthcoming  of  more  supply. 

1  Remember  that  the  marginal  demand  price  and  the  marginal  supply  price 
are  limits  beyond  which  actual  price  cannot  go,  while  the  first  extra-marginal 
supply  price  and  the  first  extra-marginal  demand  price  are  limits  to  which 
actual  price  cannot  go. 


LIMITING  PRICES  291 

In  reading  the  above  account  of  this  matter,  the  student  may 
object  that,  since  both  the  limiting  prices,  above  or  below,  fix  the 
same  price,  it  is  hardly  worth  while  distinguishing  more  than  one 
of  them.  If  actual  price  cannot  go  below  55  cents,  it  certainly  can- 
not go  down  to  54  cents ;  if  actual  price  cannot  go  above  55  cents,  it 
of  course  cannot  go  up  to  56  cents.  This  is  no  doubt  quite  true  as 
applied  to  these  perfectly  symmetrical  schedules  which  were  used 
to  explain  the  working  of  the  law  of  supply  and  demand.  We  shall 
find,  however,  that  many  schedules,  anyhow  many  supply  schedules, 
are  much  less  regular  than  those  used.  In  such  cases  only  two  or, 
sometimes,  only  one,  of  the  four  limiting  prices  may  be  actually 
operative.  Our  analysis,  therefore,  could  be  adequate  only  if  it 
brought  out  all  the  limiting  moments,  as  was  done  above. 

Applied  to  Irregular  Schedules. — To  clear  up  more  com- 
pletely the  matter  just  commented  upon,  let  us  imagine  a  schedule 
in  which  the  limits  set  by  the  different  moments  would  not  coincide. 
Thus,  in  the  accompanying  table,  demand  remains  constant  at  120,000 
ounces,  from  56  cents  to  54  inclusive,  while 
supply  icmains  constant  at  120,000  ounces 
from  58  cents  to  52  inclusive.  Since  supply  80  61  150 

and  demand  are  equal  only  at  three  prices,        ^ 
56,  55,  and  54  cents,  the  actual  price  must        no          58          120 
be  one  of  these.    But  with  actual  price  one        **°          s6 
of  these,  the  marginal  demand  price  must        120          55  120 

be   56  cents,   since  this  is   the  one   which  ^ 

brought  in  the  last  increment  of  demand;  140  52  120 
the  first  extra-marginal  supply  price  must  ^  ^  *££ 
be  59  cents,  since  this  would  bring  in  the 

next  increment  of  supply |  the  marginal  supply  price  must  be  52 
cents,  since  this  brought  in  the  last  increment  of  supply;  and  the 
first  extra-marginal  demand  price  must  be  53  cents,  since  this  would 
bring  in  the  next  increment  of  demand. 

But  actual  price,  as  already  noted,  cannot  go  above  56  cents, 
the  marginal  demand  price,  though  as  far  as  the  first  extra-marginal 
supply  price  is  concerned,  it  could  go  to  58  cents.  The  latter  price, 
therefore,  plays  no  part  in  the  final  fixing  of  the  actual  price.  Again, 


292 


PRINCIPLES  OF  ECONOMICS 


[XXIII 


actual  price  cannot  go  down  to  53  cents,  the  first  extra-marginal 
demand  price,  though,  as  far  as  the  marginal  supply  price  affects 
the  matter,  it  could  go  down  to  52  cents, — supply  does  not  begin  to 
fall  off  till  51  cents  has  been  reached.  Plainly,  then,  in  a  case  of 
this  sort,  two  of  the  limiting  moments  of  price,  those  which  come 
from  supply,  are  inoperative, — both  the  upper  and  lower  limits  of 
price  being  fixed  by  demand  prices.  Further,  it  is  plain  that  both 

of  the  moments  coming  from 
the  demand  side  have  to  be 
taken  into  account ;  for  neither 
actually   fixes  price,   each  of 
F  E.  M.     them   only   fixes   one   of   the 
*•  s.  P.        limits  within  which  price  may 
range. 

These  points  just  brought 
out  are  presented  in  the  ac- 
companying figure.  The  rect- 
angles DD'  and  SS'  represent 
two  guide  posts  between  which 
Ks  P  moves  a  counterweight  repre- 
sented by  the  rectangle  AP. 
The  guide  post  DD'  stands  for 
a  series  of  demand  prices 
from  48  cents  to  62  cents ;  SS' 
stands  for  a  series  of  supply 
prices  covering  the  same 
range;  the  counterweight  AP 

stands  for  actual  price;  and  the  triangles  projecting  inward  from  the 
left-hand  post  represent  the  limits  of  price  movement  set  by  demand 
prices,  while  those  from  the  right-hand  post  represent  the  limits  set 
by  supply  prices.  Since  actual  price  must  not  go  above  the  marginal 
demand  price,  56  cents,  it  cannot  go  as  high  as  the  first  price  above 
this,  57  cents ;  hence  the  stop  block  representing  the  limit  fixed  by  the 
marginal  demand  price  is  set  at  a  price  of  57  cents.  On  the  other 
hand,  since  actual  price  cannot  go  down  to  the  first  extra-marginal 
demand  price,  53  cents,  the  stop  block  which  represents  the  limit  set 
by  the  first  extra-marginal  demand  price  is  set  at  53  cents.  Turn- 


'D1  'S 

The  Four  Limiting  Prices 


XXIII]  LIMITING  PRICES 

ing  now  to  the  side  of  supply,  since  actual  price  must  not  go  below 
the  marginal  supply  price,  52  cents,  it  must  not  go  as  low  as  the  next 
price,  51  cents;  hence  the  lower  stop  block  on  the  supply  side  is  set  at 
51  cents.  On  the  other  hand,  since  actual  price  must  not  go 
as  high  as  the  first  extra-marginal  supply  price,  59  cents,  the  upper 
stop  block  on  the  supply  side  is  set  at  59  cents.  Manifestly,  the  two 
limits  set  by  demand  prices  are  inside  those  set  by  supply  prices; 
hence  they  only  would  be  operative  under  this  hypothesis. 

Reverse  of  Last. — In  the  schedule  just  used  to  show  that 
only  a  part  of  the  four  limiting  prices  may  be  operative  in  any  par- 
ticular case,  supply  remained  constant  for  a  longer  series  of  prices 
than  demand,  and  so  was  prevented  from  taking  part  in  actual  price 
determination.  It  is  manifest  that,  if  the  hypothesis  had  been  re- 
versed, the  results  also  would  have  been  reversed :  the  limits  of  price 
variation  would  then  have  been  fixed  by  the  marginal  supply  price 
and  the  first  extra-marginal  supply  price.  While  buyers  would 
not  have  permitted  actual  pi  ice  to  go  below  the  former  point  lest 
this  should  have  shut  out  a  portion  of  supply,  sellers  would  not 
have  permitted  actual  price  to  go  up  to  the  latter  point,  lest  this 
should  have  let  in  a  new  supply.  A  special  variation  of  this  second 
case  is  of  much  practical  importance,  namely,  one  in  which  the 
two  limiting  supply  prices,  the  marginal  and  the  first  extra-marginal 
ones,  coincide — the  price  necessary  to  bring  out  a  given  supply  and 
the  one  necessary  to  bring  out  the  next  increment  of  supply  are 
the  same.  This  is  the  case  of  constant-cost  goods  to  be  commented  on 
later. 

Other  Cases. — It  is  hardly  necessary  to  add  that  the  two 
types  of  schedules  just  used  do  not  exhaust  the  possible  variations 
from  our  original  situation.  Another  could  be  imagined  under  the 
working  of  which  the  upper  limit  of  price  would  be  set  by  the 
marginal  demand  price,  while  the  lower  would  be  set  by  the  marginal 
supply  price.  Under  still  another  type,  the  upper  limit  would  be 
set  by  the  first  extra-marginal  supply  price,  and  the  lower  by  the 
first  extra-marginal  demand  price.  Many  others  beside  these  could 
be  imagined. 


294  PRINCIPLES  OF  ECONOMICS  [XXIII 

Summary. — In  general,  there  are  two  determinants  of  both 
the  upper  and  lower  limits  of  price  variation.  The  determinants  of 
the  upper  limit  are  the  marginal  demand  price  and  the  first  extra- 
marginal  supply  price :  the  former  fixes  the  point  above  which  actual 
price  must  not  go;  the  latter  fixes  the  point  to  which  actual  price 
must  not  go.  The  determinants  of  the  lower  limit  are  the  marginal 
supply  price  and  the  first  extra-marginal  demand  price:  below  the 
former  actual  price  must  not  go  and  to  the  latter  actual  price  must 
not  go. 

In  all  cases  in  which  the  variations  in  the  prices  necessary  to  effect 
changes  in  the  volume  of  demand  or  supply  are  considerable,  only 
one  of  the  two  upper  or  lower  determinants  is  likely  to  be  effective. 

Other  Demand  and  Supply  Prices  Assist. — The  purpose  of 
the  preceding  discussion  was  to  emphasize  the  immediate  dependence 
of  actual  price  on  one  or  more  of  just  four  demand  and  supply 
prices.  To  avoid  possible  misunderstanding,  it  is  perhaps  best  to 
insert  a  caution  at  this  point.  In  giving  so  decisive  a  place  to 
certain  special  demand  and  supply  prices,  we  do  not  mean  that  other 
demand  and  supply  prices  have  no  part  in  the  matter.  To  establish 
any  price  whatever,  demand  and  supply  must  come  to  an  equality. 
With  the  schedule  which  appears  on  page  291,  this  equality  of 
demand  and  supply  was  reached  with  each  at  120,000  ounces,  and 
at  an  actual  price  of  56,  55,  or  54  cents.  But  with  neither  demand 
nor  supply  was  this  total  brought  out  by  the  last  or  marginal  price 
acting  alone.  Thus,  the  marginal  demand  price,  56  cents,  con- 
tributed to  this  total  only  10,000  ounces,  110,000  ounces  coming 
down  from  previous,  higher  prices.  If  these  earlier  increments  of 
demand  had  not  come  in, — if  the  total  demand  had  been  limited 
to  the  10,000  ounces  which  appear  at  56  cents, — equality  of  demand 
and  supply  could  have  been  reached  only  at  a  much  lower  point, 
and,  so,  actual  price  would  have  been  much  lower.  The  whole 
demand  of  120,000  ounces  was  necessary  to  make  possible  an  actual 
price  as  high  as  56  cents.  It  follows  that  the  intra-marginal  demand 
prices,  the  prices  which  were  able  to  bring  out  the  earlier  increments 
of  demand,  have  a  part  in  the  fixing  of  the  actual  price  as  truly 
as  do  the  marginal  and  the  first  extra-marginal  demand  prices. 


XXIII]  LIMITING  PRICES 


295 


The  Four  Occupy  Key  Positions. — But  now  we  must  be 
careful  lest,  in  trying  to  avoid  one  misunderstanding,  we  fall  into 
another  equally  objectionable.  Although  we  admit  that  demand 
and  supply  prices  other  than  the  marginal  and  first  extra-marginal 
oiies  share  in  the  fixing  of  actual  price,  we  by  no  means  relinquish 
the  contention  that  the  limits  of  actual  price  are  immediately  de- 
termined by  one  or  more  of  the  four  prices  named.  While  total 
demand  is  obviously  made  up  of  the  sum  of  all  the  increments  of 
demand,  these  different  increments  must  not  be  thought  of  as  per- 
fectly homogeneous  units  entering  into  the  total  in  just  the  same 
way.  The  case  is  not  analogous  to  that  of  a  pair  of  scales,  the 
measuring  pan  of  which  is  loaded  with  several  different  weights 
to  balance  the  object  being  weighed.  In  bringing  down  the  pan, 
each  of  those  weights  acts  in  just  the  same  way  as  every  other.  The 
case  is  quite  otherwise  with  the  different  increments  of  demand  or 
supply.  While  all  influence  the  result,  they  function  quite  differently 
in  doing  this.  The  explanation  is  that  each  increment  is  in  a  very 
important  sense  different  from  every  other.  This  difference  consists 
in  the  fact  that  the  emergence  of  any  one  depends  on  the  appear- 
ance of  its  own  special  price,  or  one  lower,  in  the  case  of  demand, 
or  one  higher,  in  the  case  of  supply.  This  being  true,  the  different 
increments  cannot  be  treated  as  interconvertible,  as  if  each  played 
a  like  role  with  every  other.  The  lowest-priced  of  all  the  demand 
increments  and  the  highest-priced  of  all  the  supply  increments  hold 
key  positions.  Any  price  which  will  bring  them  out  can  prevail, 
even  though  it  differs  ever  so  much  in  one  direction  from  the  special 
price  necessary  to  bring  out  any  other  increment  of  the  total.  On 
the  other  hand,  no  price  which  does  not  bring  them  out  can  prevail, 
though  it  brings  out  every  other  increment  of  either  demand  or  sup- 
ply. In  short,  the  immediate  determination  of  price  limits  is  with 
the  four  demand  and  supply  prices  which  have  been  so  often  named ; 
the  part  of  other  demand  and  supply  prices  is  to  assist  in  determin- 
ing what  prices  shall  occupy  these  key  positions. 

Illustration  from  Analogy. — In  closing  this  rather  long  dis- 
cussion, I  am  going  to  add  one  more  illustration  from  analogy  to  the 
very  considerable  number  which  have  been  used  by  different  writers 


296  PRINCIPLES  OF  ECONOMICS  [XXIII 

in  this  connection.  Suppose  that  the  owner  of  a  meat  market  lo- 
cated in  a  small  town  starts  out  to  buy  a  dozen  cattle  among  the 
neighboring  farmers,  and  that  he  can  get  two  from  the  first  farm 
on  his  route,  one  from  the  second,  three  from  the  third,  one  from 
the  fourth,  and  so  on.  How  far  will  he  have  to  go  to  get  the  whole 
twelve?  Manifestly,  the  answer  is:  As  far  as  the  distance  to  the 
farm  at  which  he  buys  the  last  one  or  more  necessary  to  make  up  the 
full  number.  In  other  words,  the  total  distance  to  be  traversed 
will  depend  immediately  on  the  distance  to  the  marginal  increment, 
and,  immediately,  on  that  only.  But  this  distance,  in  turn,  will 
manifestly  depend  in  part  on  the  increments  obtainable  at  farms 
nearer  by.  In  consequence,  these  earlier  increments  share  in  de- 
termining the  total  distance.  Their  influence,  however,  is  only  in- 
direct. They  help  to  make  the  total  distance  short  or  long  because, 
and  in  so  far  as,  they  make  the  distance  to  the  marginal  increment 
short  or  long. 

ILLUSTRATIVE  PROBLEMS 

1.  The  holding  up  of  prices  always  depends  on  the  bidding  of  in- 
cluded buyers;  the  holding  down  of  prices  depends  on  the  bidding  of 
included  sellers.     Explain  the  meaning  of  that  statement  and  maintain 
its  correctness. 

2.  While   the  proposition  laid  down  in  the  preceding  problem   is 
entirely  sound,  it  is  still  true  that  the  attitude  of  sellers  has  a  part  in 
holding  up  price ;  while  that  of  buyers  has  a  part  in  holding  down  price. 
Defend  that  statement. 

3.  Change  the  demand  and  supply  schedule  on  page  291   so  that 
the  limits   of  price-variation   would  be   fixed   by   the   marginal   supply 
price  and  the  first  extra -marginal  supply  price. 

4.  Two  conditions  are  really  necessary  to  the  existence  of  a  price  for 
any  commodity  or  service :     ( I )  the  demand  at  some  price  above  zero 
must  be  as  great  as  any  supply  which  will  be  forthcoming  at  that  price, 
and  (2)  the  demand  at  zero  price  must  be  greater  than  any  supply  which 
will  be  forthcoming  at  that  price.     Defend  that  statement  with  respect 
to  both  conditions. 

5.  "On  the  other  hand,  if  the  price  fell  to  4  cents,  the  demand  would 
exceed  the  supply  by  500  pounds,  and  those  demanding  this  extra  amount 


XXIII]  LIMITING  PRICES  297 

•would  be  unable  to  get  it  except  by  bidding  a  higher  price,  and  so  their 
competition  would  drive  price  up."     Criticize. 

6.  "On  account  of  the  very  weak  bargaining  power  of  the  laborer, 
there  is  nothing  to  hinder  the  rate  of  wages  from  going  down  to  the 
lowest  amount  laborers  can  be  induced  to  take."     Criticize. 

7.  "Five  persons  from  a  shipwrecked  steamer  are  temporarily  saved 
by  getting  on  a  raft;  a  sixth  climbs  on,  and  the  raft  sinks.     Obviously  it 
was  not  just  the  sixth  person  who  sank  the  raft,  but  all  the  six  persons. 
No  more  do  the  marginal  and  first  extra-marginal  demand  and  supply 
prices  by  themselves  fix  actual  price.     All  the  demand  and  supply  prices 
equally  share  in  the  process." 

Show  that  the  analogy  is  false. 


CHAPTER  XXIV 

NORMAL  DEMAND  SCHEDULES 

At  the  beginning  of  the  last  cnapter,  it  was  explained  that  our 
study  of  price-determination  was  to  be  divided  into  three  parts 
according  as  it  was  concerned  with  the  immediate,  the  intermediate, 
or  the  ultimate  stages  of  price-determination.  The  first  of  these 
stages  has  already  been  covered.  In  the  present  chapter,  we  begin 
our  study  of  the  second. 

Need  for  Normal  Price  Theory. — The  necessity  for  a  separate 
treatment  of  these  two  stages  can  be  made  clear  by  means  of  an 
illustration.  In  the  early  nineties  of  the  last  century  the  bicycle, 
which  had  just  recently  been  invented,  was  in  process  of  evolution. 
At  that  time,  the  price  of  any  machine  likely  to  prove  serviceable 
to  the  buyer  was  in  the  neighborhood  of  $100  to  $125.  That  this 
price  was  more  or  less  fully  the  result  of  the  natural  working  of 
the  laws  of  price  which  were  considered  in  our  last  chapter,  there 
can  be  no  question ;  at  any  rate  it  was  doubtless  one  which  brought 
demand  and  supply  into  approximate  equality.  However,  the  price 
was  believed  by  all  well-informed  persons  to  be  something  quite 
temporary  in  character.  Prospective  buyers  with  lean  pocket-books 
or  with  more  than  the  usual  amount  of  prudence  and  patience  con- 
fidently expected  and  waited  for  a  decided  fall.  "The  present 
price,"  said  they,  "is  plainly  abnormal.  Doubtless  for  the  time  being 
various  causes  may  enable  producers  to  hold  the  price  up  to  $100; 
but  this  cannot  last  many  years." 

Here  we  find  implied  the  chief  reason  for  distinguishing  between 
the  study  of  the  immediate  processes  of  price-determination  which 
occupied  the  last  two  chapters  and  the  study  of  deeper  processes 
which  begins  in  this.  Behind  the  price  temporarily  prevailing  under 
the  influence  of  immediate  forces,  there  is  a  price  which  tends  to  be 

298 


XXIV]  NORMAL  DEMAND  SCHEDULES  299 

established  by  the  more  permanent  forces  and  toward  which  the 
actual  price  is  constantly  being  driven.  And  this  other  price,  which 
we  call  the  "normal,"  is  in  the  long  run  of  far  greater  significance 
than  the  one  established  by  immediate  forces.  Three  chapters  will 
therefore  be  given  to  the  study  of  normal  price ;  this  chapter  and  the 
next  to  preliminary  matters,  and  the  last  to  the  actual  processes  of 
normal  price-determination. 

Meaning  of  Normal  Price. — While  the  meaning  of  the  phrase 
"normal  price"  is  indicated  in  the  last  paragraph,  an  additional 
comment  or  two  may  serve  to  make  it  clearer.  It  means  a  price 
which  is  always  tending  to  prevail  during  a  given  period  as  a  result 
of  the  action  of  those  forces  which  operate  throughout  the  period, 
especially  the  larger  of  those  forces.  But,  though  always  tending  to 
prevail,  we  should  note  that,  because  of  the  interference  of  tempo- 
rary forces,  normal  price  seldom  if  ever  does  prevail;  and  for  this 
reason  it  is  often  denned  as  the  price  toward  which  actual  price 
constantly  gravitates,  or  about  which  actual  price  constantly  oscil- 
lates. Again,  normal  price  should  not  be  confused  with  average 
price,  which  is  a  mere  arithmetic  concept.  The  two  might  coincide 
quantitatively,  though  it  is  probable  that  they  seldom  do.  In  any 
case,  they  differ  radically  in  meaning  or  connotation;  and,  if  a 
certain  price  were  at  once  the  average  of  all  actual  prices  for  a 
given  period  and  the  price  tending  to  be  established  by  the  permanent 
forces  of  that  period,  we  should  call  it  a  normal  price  solely  because 
it  fulfilled  the  second  condition. 

Supply  and  Demand  Not  Superseded. — One  of  the  first  mat- 
ters to  be  emphasized  in  connection  with  normal  price  is  that  the  law 
of  supply  and  demand  already  presented  still  governs  the  immediate 
processes  of  price  determination.  In  creating  a  tendency  for  some 
particular  price  to  prevail,  the  permanent  forces  necessarily  operate 
through,  and  only  through,  their  power  to  influence  the  immediate 
demand  or  supply  schedule.  Thus,  if  certain  forces  tend  to  estab- 
lish a  normal  price  of  30  cents  for  wooden  chairs,  they  do  this 
simply  because  they  have  the  power  so  to  influence  the  supply 
schedule  that  every  time  the  price  goes  above  or  below  30  cents,  a 


300  PRINCIPLES  OF  ECONOMICS  [XXIV 

tendency  is  established  to  pull  it  back  to  that  point  under  the  natural 
working  of  the  Law  of  Supply  and  Demand. 

But  the  law  of  supply  and  demand  dominates  normal  price  in 
a  deeper  sense.  Besides  the  immediate  demand  and  supply  schedules 
which  at  any  moment  prevail  there  are  long-time  or  normal  demand 
schedules  and  long-time  or  normal  supply  schedules  covering  the 
whole  period  under  consideration.  Thus,  when  the  immediate  de- 
mand schedule  for  silver  on  a  particular  day  in  1918  was  20,000 
ounces,  if  price  were  60  cents;  22,000,  if  59;  25,000,  if  58; — there 
must  also  have  been  a  schedule  for  the  whole  year  1918,  a  schedule 
which  might  have  read  something  like  this :  260,000,000  ounces 
wanted  if  price  were  60  cents;  275,000,000,  if  it  were  59;  290,- 
000,000,  if  58.  Similarly,  alongside  the  immediate  supply  schedule 
there  must  also  have  been  a  long-time  supply  schedule  on  a  much 
larger  scale. 

Now  the  price  which  is  tending  to  be  established  all  through  this 
period — the  normal  price, — is  determined  by  the  relation  between 
these  long-time  or  normal  demand  and  supply  schedules.  Thus, 
suppose  that  the  schedules  for  silver  given  on  page  281  represent 
the  long-time  supply  and  demand  conditions  for  that  metal,  rather 
than  the  immediate  ones.  Then  the  price  which  these  schedules 
would  naturally  establish,  55  cents,  would  tend  to  be  the  normal 
price  for  the  whole  period,  one  year ;  just  as,  in  the  example  given, 
it  tended  to  be  the  market  price  for  the  single  day  when  those 
schedules  were  effective.  With  these  long-time  schedules,  as  with 
the  market  schedules,  there  would  be  one  and  only  one  price  at  which 
demand  and  supply  were  equal ;  and,  under  the  normal  working 
of  economic  forces,  this  one  price  would  tend  to  be  established.  In 
undertaking  our  deeper  study  of  price,  therefore,  we  are  not  leaving 
behind  the  law  of  supply  and  demand,  but  merely  bringing  out  forces 
and  processes  which  lie  a  little  deeper.  In  fact,  all  our  later  ex- 
position of  the  theory  of  price  will,  in  a  sense,  do  little  more  than 
elaborate  and  complete  our  account  of  the  principles  of  supply  and 
demand. 

Normal  Demand  Schedules. — We  have  seen  that  the  deeper 
forces  determining  normal  price  necessarily  act  through  supply  and 


XXIV]  NORMAL  DEMAND  SCHEDULES  301 

demand, — long-time  supply  and  long-time  demand;  so  that  behind 
normal  price  we  find  normal  supply  and  demand  schedules,  just 
as  behind  market  price  we  find  market  supply  and  demand  schedules. 
The  remainder  of  this  chapter  will  be  devoted  to  normal  demand 
schedules. 

Begin  with  Individual  Schedules. — In  analyzing  normal  de- 
mand schedules,  our  first  need  is  to  consider  the  deeper  factor  or 
element  which  lies  behind  demand  prices.  What  determines  the 
prices  which  in  the  long  run  buyers  stand  ready  to  pay  for  a  given 
quantity  of  goods?  In  answering  this  question,  it  is  necessary  that 
we  should  go  to  the  schedule  of  the  individual  buyer  and  ask 
ourselves  what  motive  or  motives  finally  determine  his  conduct.  For, 
obviously,  the  general  or  social  schedules  with  which  we  have  to 
deal  are  composites  or  aggregates  of  numerous  individual  schedules. 
Thus,  when  we  say  that,  according  to  the  general  demand  schedule 
for  silver,  180,000,000  ounces  are  wanted  if  price  is  55  cents,  we 
mean  that  the  different  amounts  of  demand  at  55  cents  from  the 
schedules  of  all  the  different  buyers  of  silver  will,  when  added  to- 
gether, give  a  sum  of  180,000,000  ounces. 

The  student  should  not,  of  course,  be  misled  by  this  emphasis 
upon  the  priority  of  individual  schedules  over  the  general  market 
schedule,  into  thinking  those  individual  demand  schedules  are  made 
up  independently  of  social  forces.  The  wants  of  any  individual,  and, 
therefore,  the  valuations  which  he  puts  upon  goods,  are  necessarily 
in  a  very  great  measure  the  creation  of  the  community  in  which  he 
lives,  just  because  his  standards,  ideals,  and  tastes  arc  in  great  meas- 
ure the  creation  of  that  community.  We  are  born  into  the  family, 
into  society,  into  the  state;  and  our  ideals  are  never  formed  inde- 
pendently of  these  groups.  But  this  admission  does  not  at  all  conflict 
with  our  doctrine  that  the  demand  schedules  of  the  market  are  com- 
posites, made  up  by  adding  together  the  demand  schedules  of  indi- 
viduals. For,  however  large  may  be  the  share  of  social  forces  in 
the  determination  of  our  wants,  those  forces  finally  express  them- 
selves through  the  demand  of  individual  men.  Goods  are  purchased 
not  by  the  group  will,  nor  by  the  group  ideal,  but  by  concrete  and 
separate  persons.  We  proceed,  therefore,  to  consider  the  normal 


302 


PRINCIPLES  OF  ECONOMICS  [XXIV 


demand  schedules  of  the  individual.  Here  our  chief  task  is  to  study 
the  principles  which  regulate  individual  demand  prices  and  the  forces 
lying  behind  them. 

Demand  Price  and  Marginal  Valuation. — First,  let  us  remind 
ourselves  that  each  demand  price  appearing  in  the  schedule  of  the 
individual  is  the  price  which  is  necessary  to  induce  him  to  purchase 
the  corresponding  quantity  of  the  goods  in  question.  But,  secondly, 
we  must  remember  that  the  price  in  question  was  necessary  only  in 
the  case  of  the  last  increment  of  the  total  amount  involved.  For 
earlier  increments  of  that  total  the  prospective  buyer  would  have  been 
willing  to  pay  higher  prices.  Immediately,  then,  his  demand  price 
for  a  given  total  is  really  his  demand  price  for  the  last  increment  of 
that  total. 

It  follows,  therefore,  that,  in  tracing  causation  in  the 
case  of  demand  prices,  we  have  to  follow  the  history  of  the  mar- 
ginal demand  price.  Accordingly,  what  is  the  immediate  cause 
which  makes  the  prospective  buyer's  marginal  demand  price  what 
it  is? 

Surely  the  answer  is  that  such  cause  is  the  valuation  which  the 
buyer  puts  on  that  last  increment.  He  puts  that  price  on  the  volume 
of  demand  of  which  this  is  the  last  increment,  because  he  esteems 
such  last  increment  that  much — sets  that  much  store  by  its  possession. 
Thus,  if  his  schedule  for  apples  reads  as  follows:  one  peck  wanted  if 
price  is  $2.00;  two  if  price  is  $1.50;  three  if  price  is  $1.25;  and  so 
on,  this  shows  that  he  values  a  single  peck  at  $2.00 ;  a  second  at  $1.50 ; 
a  third  at  $1.25 ;  and  so  on. 

Valuation  Based  on  Significance. — But,  again,  these  valua- 
tions of  the  prospective  customer  must  have  something  behind  them. 
There  must  be  a  reason  for  valuing  the  apples  in  our  illustration. 
That  reason,  immediately  speaking,  is  the  fact  that  the  apples  have 
significance  or  importance  for  the  welfare  of  the  prospective  custom- 
er, and  the  further  fact  that  he  realizes  that  they  have  such  signifi- 
cance. Because  of  these  facts  he  attaches  value  to  the  apples  and 
gives  measurement  to  that  value  in  terms  of  a  common  measure, 
usually  money.  In  short,  the  valuations  of  the  customer  are  his 


XXIV]  NORMAL  DEMAND  SCHEDULES  303 

estimates  of  the  significance  or  importance  to  himself  of  the  several 
increments  of  apples  or  whatever  good  is  in  question.1 

It  is  hardly  necessary  to  say  that  these  valuations,  these  estimates 
by  the  individual  of  the  significance  of  particular  increments  of  goods, 
lack  the  precision  which  would  be  required  in  most  other  measure- 
ments of  a  scientific  character.  Nevertheless,  these  estimates  are 
very  real  and  sufficiently  precise  for  the  purposes  of  economic  life, 
as  is  abundantly  proved  by  the  fact  that,  if  in  view  of  all  the  circum- 
stances the  price  seems  reasonable,  our  buyer  actually  decides  in 
favor  of  the  apples  rather  than  using  his  money  to  buy  something 
else. 

Significance  Based  on  Utility. — We  have  seen  that  the  de- 
mand prices  of  buyers  grow  out  of  the  valuations  which  those  buyers 
put  on  the  goods,  and  that  these,  in  turn,  grow  out  of  the  significance 
or  importance  to  said  buyer  of  the  goods  in  question.  But,  plainly, 
we  are  not  yet  at  the  bottom  of  the  matter.  Why  do  goods  have 
significance  to  the  individual,  and  what  determines  the  degree  of  their 
significance?  The  immediate,  and  from  the  economist's  standpoint, 
the  ultimate  ground  of  signficance  or  importance  in  any  commodity 
or  service  is  the  utility  of  that  commodity  or  service,  its  capacity 
to  satisfy  wants,  to  make  some  contribution  to  our  welfare.  Because 
things  can  bring  us  advantage,  they  have  significance  or  importance 
for  us ;  having  such  significance,  we  value  them ;  because  they  are 
valued  by  us,  we  stand  ready  to  give  a  price  for  them.  Our  demand 
prices  for  things,  therefore,  are  the  final  result  of  a  series  of  causes 
beginning  with  utility.2 


1  Remember  that  these  are  the  valuations  of  the  individual  interested,  not 
those  of  some  absolute  intelligence  outside  himself  nor  those  of  society  as  a 
whole.    How  far  they  are  of  interest  from  the  standpoint  of  society  at  large 
will  have  to  be  considered  in  later  connections. 

2  The  above  account  of  the  causes,  forces,  lying  behind,  and  determining 
demand   schedules  confines   its   attention   to   the  demand   schedules   of   con- 
sumers in  the  strict  sense,  that  is,  persons  who  wish  to  buy  the  commodity 
in  question  as  a  means  of  satisfying  some  want,  though  some  portion  of  the 
demand    for  the   same   commodity  often   comes   from   producers,   while  the 
demand   for   some   types   of  goods   comes   almost   entirely    from   producers. 
It   can   scarcely  be  doubted,  however,  that,  indirectly  and  in  the   long  run, 
the  attitude  of  consumers  must  be  decisive  in  determining  that  of  producers, 
else   the   latter   would   find   themselves   bankrupt.     The   processes   by   which 
this    result   is   reached   are   necessarily   obscure ;    but    some   notion   of   their 
character  will  be  brought  out  in  Chapters  XXIX  and  XXX. 


304 


PRINCIPLES  OF  ECONOMICS  (XXIV 


Diminishing  Marginal  Utility. — Our  analysis  has  brought  us 
to  utility  as  lying  behind  and  determining  the  significance  of  products 
to  buyers,  just  as  these  lie  behind  and  determine  the  valuations  of 
buyers,  just  as  these,  in  turn,  lie  behind  and  determine  the  demand 
prices  of  buyers.  From  the  standpoint  of  the  economist,  this  brings 
us  very  near  the  end  of  the  matter.  It  might  indeed  be  argued  that, 
since  utility  is  the  capacity  to  satisfy  wants,  we  ought  now  to  under- 
take a  careful  study  of  the  nature  and  origin  of  wants  and  the  pe- 
culiarities or  qualities  of  things  which  fit  them  to  satisfy  those 
wants.  As  a  matter  of  fact,  we  mostly  leave  these  things  to  investi- 
gators in  other  fields.  In  the  present  connection,  anyhow,  we  shall 
confine  ourselves  to  a  single  fact  about  wants,  and  that  a  fact  which 
is  so  familiar  to  everyone  that,  when  understood,  it  is  at  once  ac- 
cepted. That  fact  is  that,  in  most  cases,  the  process  by  which  a  want 
is  satisfied  to  the  point  of  satiation  is  one  which  may  be  characterized 
as  a  declining  progression.  That  is,  said  satisfaction  has  to  take 
place  in  successive  stages  and  the  addition  to  gratification  derived 
from  the  addition  of  a  unit  of  commodity  is  each  time  less  than 
proportional.  Thus,  if  one  were  quite  hungry,  a  single  slice  of 
bread  would  give  very  great  gratification ;  a  second  would  give  some- 
what less ;  a  third  decidedly  less ;  and  so  on ;  till  satiation  was  reached.3 
It  follows  that  the  gratification  derivable  from  the  last  unit  of  a  given 
quantity  of  any  commodity  is  bound  to  be  smaller  than  that  derivable 
from  the  last  unit  of  a  smaller  quantity  of  that  commodity.  But,  in 
view  of  our 'use  of  the  word  "marginal"  in  other  connections,  we 
naturally  designate  the  gratification  derivable  from  the  last  unit  of 
a  given  quantity  of  any  commodity  the  ''marginal"  gratification. 
Hence  we  say  that  the  marginal  gratification  derivable  from  a  given 
quantity  of  any  commodity  diminishes  as  the  quantity  of  that  com- 
modity consumed  increases.  But  it  is,  of  course,  implicit  in  this 
statement  that  the  power  of  marginal  units  of  any  commodity  to  give 
gratification  diminishes  as  the  quantity  in  possession  increases.  Fur- 
ther, the  power  of  a  commodity  to  give  gratification  we  call  its  utility. 
Hence  we  have  the  following  principle : 


'  Doubtless  this  account  of  the  matter  does  not  apply  to  all  cases ;  but  it 
is  of  sufficiently  general  application  to  be  of  great  importance 


XXIV]  NORMAL  DEMAND  SCHEDULES  305 

Principle — The  Principle  of  Diminishing  Marginal  Utility. 

The  marginal  utility  of  any  economic  good  varies  in- 
versely as  the  quantity  at  disposal. 

Diminishing  Effective  Significance. — Since,  as  we  saw  above, 
the  utility  of  any  commodity  is  the  source  from  which  its  significance 
or  importance  is  derived,  it  follows  that,  if  the  marginal  utility  of  a 
given  commodity  diminishes  as  the  quantity  at  disposal  increases,  the 
marginal  significance  of  such  a  commodity  must  also  diminish  in  the 
same  way.  But  we  can  go  further.  Not  only  does  the  marginal 
significance  of  such  a  commodity  diminish  with  its  quantity,  the 
effective  significance  of  every  unit  of  that  quantity  also  has  the  same 
experience.  That  is,  its  effective  significance  cannot  be  greater  than 
the  significance  of  the  marginal  unit.  The  true  importance  of  any 
commodity  is  determined  by  the  loss  which  we  should  experience  if 
deprived  of  a  unit  of  that  commodity.  But,  since  different  units  of 
commodity  are  interchangeable,  it  is  quite  certain  that,  if  deprived  of 
a  particular  unit,  we  would  not  permit  ourselves  to  be  deprived  of 
one  of  the  higher  gratifications  to  be  derived  from  such  a  unit  of 
that  commodity.  Instead,  we  should  relinquish  the  lowest  gratifica- 
tion of  all,  withdrawing,  if  necessary,  the  unit  formerly  put  to  the 
marginal  use  from  that  marginal  use  and  devoting  it  to  the  higher 
service  which  had  formerly  been  cared  for  by  the  lost  unit.  In  short, 
the  effective  significance  of  any  commodity  varies  inversely  as  the 
quantity  of  that  commodity  at  our  disposal. 

Diminishing  Valuation. — Having  now  reached  the  conclusion 
that  the  significance  of  a  commodity  varies  inversely  as  the  quantity 
in  possession,  we  inevitably  take  another  step  and  recognize  the  ex- 
istence of  a  similar  law  for  valuation.  Since  the  effective  significance 
or  importance  of  a  commodity  diminishes  with  the  quantity  at  our 
disposal,  it  necessarily  follows  that  our  valuation  of  such  a  com- 
modity takes  the  same  course.  If  a  unit  of  a  given  commodity  has 
less  effective  importance  than  hitherto  because  I  have  at  my  disposal 
a  larger  quantity,  and  my  want  schedule  for  that  commodity  has  not 
altered,  I  will  naturally  evaluate  that  commodity  at  a  lower  figure 


306  PRINCIPLES  OF  ECONOMICS  [XXIV 

That  is,  the  consumer's  valuation  of  a  commodity  varies  inversely 
as  the  quantity  at  his  disposal  or  that  conceived  to  be  at  his  dis- 
posal. 

Diminishing  Demand  Prices. — We  come,  finally,  to  the  de- 
mand prices  of  the  consumer.  These  surely  must  take  the  same 
course  as  has  his  valuation.  That  is,  when  he  is  contemplating  the 
purchase  of  a  certain  number  of  units  of  a  commodity,  the  price 
upon  which  will  be  conditioned  his  taking  that  quantity  will  depend 
on  the  valuation  which  he  has  put  upon  said  quantity.  His  demand 
prices,  therefore,  will  take  the  same  course  as  his  valuations.  That 
is,  the  demand  prices  of  a  prospective  buyer  vary  inversely  as  the 
quantity  of  the  commodity  which  he  conceives  himself  to  be  pur- 
chasing. 

These  analogous  propositions  with  respect  to  valuations  and 
demand  prices  are  illustrated  in  the  diagram  of  Figure  I.  Valua- 
tions or  prices  are  measured  vertically  on  the  line  at  the  left,  while 
the  quantity  of  the  commodity  supposed  to  be  in  possession,  actual 
or  contemplated,  is  measured  along  the  horizontal  line  at  the  base. 
The  heavy  verticals  side  by  side  indicate  the  valuation  or  demand 
price  attached  to  the  particular  quantity  of  the  commodity  which  is 
measured  by  the  distance  from  zero  to  the  point  where  the  vertical 
is  erected.  The  commodity  under  consideration  is  supposed  to  be 
sugar,  the  unity  of  quantity  5  pounds,  and  that  of  valuation  or  price 
5  cents.  Thus  if  the  quantity  be  5  pounds,  its  valuation  or  demand 
price  will  be  indicated  by  the  tallest  vertical  at  the  left,  that  is,  will 
be  100  cents;  if  the  quantity  be  10  pounds  its  valuation  or  demand 
price  will  be  represented  by  the  second  vertical,  that  is,  will  be  65 
cents ;  and  so  on.  The  line  of  causation, — the  fact  that  in  this  prin- 
ciple the  quantity  of  the  commodity  is  the  condition  and  the  utility 
or  significance  or  valuation  or  demand  price  the  consequence, — is 
indicated  by  the  vertical  arrows  starting  from  the  base  line  on  which 
quantity  is  measured.  As  required  by  our  principles,  the  verticals 
representing  valuations  or  demand  price  grow  shorter  with  every 
increase  in  the  quantity  assumed,  being,  for  example,  75  cents  for 
30  pounds;  45  cents  for  60  pounds;  30  cents  for  75  pounds;  and 
so  on. 


XXIV] 


NORMAL  DEMAND  SCHEDULES 


307 


Inverse  Elasticity  of  Demand. — Very  little  reflection  should 
be  necessary  to  convince  the  student  that,  in  the  principle  just  brought 
out,  we  have,  in  part  anyhow,  the  explanation  of  the  principle  of 
the  Inverse  Elasticity  of  Demand  discussed  in  Chapter  XX.  Since 
the  consumer's  valuation  and  demand  price  for  the  first  5  pounds  of 
sugar  is  $1.00,  it  necessarily  follows  that  an  actual  price  of  $1.00 


100- 


75- 


50- 


25- 


III, 


f  t  t  t  t  t  1 1  1 1  t  t  t  t  t  M  1 1  ' 
i  i  i  i  I  i  i  i  i  I  i  i  i  i  I  i  i  i  i   ii 

25  50  75  100 

Figure  i.     Utility,  Valuation,  and  Demand  Price  Schedule 

will  make  his  demand  5  pounds.  Similarly,  since  his  demand  price 
for  a  second  unit  is  95  cents,  an  actual  price  of  95  cents  will  make 
his  demand  10  pounds;  since  his  demand  price  for  15  pounds  is 
90  cents,  an  actual  price  of  90  cents  will  make  his  demand  15 
pounds ;  and  so  on.  This  is  brought  out  in  Figure  2,  which  shows 
the  particular  quantity  of  demand  resulting  from  each  actual  price. 
In  this  diagram,  therefore,  the  arrows  start  from  the  price  scale  and 
run  from  left  to  right.  A  I -dollar  price  results  in  a  5-pound  de- 


3o8 


PRINCIPLES  OF  ECONOMICS 


[XXIV 


mand ;  a  95-cent  price  results  in  a  lo-pound  demand ;  a  cp-cent  price 
results  in  a  1 5-pound  demand;  and  so  on. 

Social  Demand  Schedules. — Thus  far  we  have  considered 
only  the  demand  schedule  of  the  individual.  But,  obviously,  the 
demand  schedule  which  plays  a  decided  role  in  the  general  market 


100- 


75  — 


50 


25- 


1  1  1  1 


1    1    1    1 


i  i  i  i 


J 


J   I   I  I   I 

75  100 


0  25  50 

Figure  2.    Demand  Schedule  Resulting  from  Valuation  Schedule  in  Figure  i 

is  the  social  or  general  schedule.    Hence  we  must  bring  our  discussion 
to  a  focus  in  the  general  or  social  demand  schedule. 

Inverse  Elasticity  of  Social  Demand. — Here  the  chief  thing 
to  be  noted  is  that  the  general  schedule  shows  just  the  same  relation 
to  valuation  and  demand  price  schedules,  as  did  the  individual  de- 
mand schedule.  That  is,  the  general  demand  schedule  results  from 
the  general  valuation  and  demand  price  schedule.  Thus,  the  demand 
schedule  represented  by  the  figure  on  page  260  results  from  a 
marginal  valuation  or  demand  price  schedule  analogous  to  the  one 


XXIV] 


NORMAL  DEMAND  SCHEDULES 


309 


considered  above.  Such  a  schedule  for  silver  is  represented  in 
Figure  3.  According  to  this  diagram,  a  stock  of  70,000  ounces  has 
a  marginal  valuation  and  so  a  demand  price  of  60  cents ;  one  of  80,000 
has  a  marginal  valuation  and  so  a  demand  price  of  59  cents ;  and  so 
on.  And  it  is  because  of  these  facts  that  the  results  in  respect  to 


60 


55- 


50- 


t   t    t 


t    t   t 


0  40  80 

Figure    3.     Utility,     Valuation,     and     Demand 

Demand  Schedule 


120 
Price 


160 
Schedule 


Producing 


demand  which  appear  on  page  260  emerge.  Thus,  since  70,000 
ounces  have  a  demand  price  of  60  cents,  therefore  an  actual  price  of 
60  cents  will  bring  out  a  demand  of  70,000  ounces.  Since  80,000 
ounces  have  a  demand  price  of  59  cents,  therefore  an  actual  price  of 
59  cents  will  bring  out  a  demand  of  80,000  ounces ;  and  so  on. 

Most  Social  Demand  Schedules  Elastic. — I  will  now  close 
this  discussion  of  normal  demand  schedules  with  a  statement  regard- 
ing their  general  character.  Generally  speaking,  all  normal  demand 
schedules  are  of  the  kind  which  in  the  chapters  on  Immediate  Price 


310  PRINCIPLES  OF  ECONOMICS  [XXIV 

Determination  were  characterised  as  typical.  Doubtless  this  must 
be  affirmed  less  roundly  of  some  than  of  others.  A  few  are  relatively 
inelastic,  for  example,  those  of  the  prime  necessaries  of  life;  but, 
over  a  wide  range  of  prices,  most  schedules  show  fairly  uniform 
changes  in  demand  with  every  material  change,  in  price.  This  fact, 
as  we  may  easily  see,  is  quite  inevitable.  ( I )  General  schedules  are 
composites  of  numberless  individual  schedules.  (2)  The  tastes  and 
wants  of  individuals  differ  greatly.  (3)  Most  of  all,  the  incomes  of 
individuals  are  very  unequal.  As  a  result,  there  will  be  some  effective 
demand  at  almost  every  price  level.  Even  at  very  high  levels,  those 
who  are  rich  and  wish  a  commodity  intensely  will  continue  to  demand 
it ;  while,  with  each  fall  in  price,  some  persons  who  care  less  or  have 
smaller  incomes  or  who  fulfil  both  these  conditions  will  come  in 
with  a  new  demand.  The  general  schedule,  as  a  whole,  therefore, 
will  show  a  high  degree  of  continuity,  regularity,  and  symmetry. 

ILLUSTRATIVE  PROBLEMS 

1.  "The  common  teaching  of  economists  that  the  normal  price  of 
products  equals  cost  of  production  is  entirely  untenable.     Normal  price 
of  course  means  the  price  which  usually  prevails.     But,  now,  every  one 
knows  that  the  price  of  any  product  rarely,  if  ever,  coincides  with  its  cost 
of  production.     Hence  a  price  which  actually  did  coincide  with  cost 
would  be  an  abnormal  rather  than  a  normal  one." 

The  above  quotation  may  furnish  a  valid  reason  for  choosing  some 
word  other  than  "normal"  to  designate  what  the  economist  has  in  mind ; 
but  it  does  not  furnish  a  valid  argument  against  the  doctrine  that  the 
normal  price  of  the  economist  coincides  with  cost.  Explain. 

2.  "All  talk  about  normal  price  is  simply  silly.     There  isn't  any  such 
thing.     The  economist  teaches  that  normal  price  corresponds  to  cost  of 
production ;  whereas  every  one  knows  that,  during  the  last  two  or  three 
years  (written  in  1918),  the  prices  of  almost  all  commodities  have  been 
far  above  cost  of  production." 

Is  his  denial  of  the  existence  of  normal  price  reasonable?    Explain. 

3.  One  of  the  possible  upper  limits  of  the  actual  price  of  any  com- 
modity is  its  marginal  utility  or  significance;  while  one  of  the  possible 
lower  limits  of  that  price  is  the  first  extra-marginal  utility  or  significance 
of  said  commodity. 

Give  the  argument  needed  to  support  those  propositions. 


ft'  l-n 


CHAPTER  XXV 

NORMAL  SUPPLY  SCHEDULES 

In  the  preceding  chapter  we  considered  various  topics  prelim- 
inary to  the  study  of  normal  price,  including  normal  demand  sched- 
ules. In  this  chapter  we  continue  the  study  of  preliminaries, 
especially  matters  connected  with  supply. 

Market  Supply  Schedules. — The  supply  schedule  with  which 
we  were  concerned  in  our  first  study  of  the  processes  of  price- 
determination  is  most  naturally  designated  the  market  supply  sched- 
ule. In  that  schedule  we  are  looking  at  the  immediate  attitude  of 
sellers.  At  a  certain  time,  for  a  great  variety  of  reasons,  sellers  are 
ready  to  sell  a  certain  number  of  units  of  a  commodity  if  price  is 
so  and  so,  another  number  if  price  is  something  else,  and  so  on.  This 
attitude  of  sellers  is  a  momentary  one, — an  ever-changing  one.  If 
they  hear  a  little  different  news  as  to  conditions  in  other  markets, 
the  probabilities  of  demand  in  some  other  community,  or  the  success 
of  production  during  the  current  season,  they  will  alter  their  supply 
schedule,  will  change  the  quantity  they  are  willing  to  sell  at  any 
particular  price. 

Normal  Supply  Schedules. — We  wish  now  on  the  other  hand 
to  study  the  attitude  of  sellers  throughout  a  longer  period.  During 
a  season,  a  year,  or  a  series  of  years,  sellers  are  acted  upon  by  certain 
larger  and  more  permanent  forces,  and  under  the  influence  of  those 
forces,  they  stand  ready  to  sell  a  particular  number  of  units  of  a 
commodity  if  price  is  so  and  so,  another  number  if  price  is  some- 
thing else,  and  so  on.  This  attitude  of  sellers  is  represented  in  the 
normal  or  long-time  supply  schedules.  As  a  final  preliminary  to  our 
study  of  actual  normal  price  and  its  determination,  we  must  now 
investigate  the  nature  of  these  normal  supply  schedules. 

3" 


3I2  PRINCIPLES  OF  ECONOMICS  [XXV 

Different  Classes  of  Goods. — In  undertaking  this  task,  our 
first  step  is  to  note  some  fundamental  differences  among  goods,  since 
these  differences  are  responsible  for  marked  differences  in  the  normal 
supply  schedules  of  such  goods.  The  most  important  of  these  dif- 
ferences gives  rise  to  two  main  classes  of  goods :  ( I )  those  goods  the 
stock  or  output  of  which  is  increasable — producible  goods — and 
(2)  those  of  which  the  stock  or  output  is  fixed.  The  first  obviously 
includes  the  great  majority  of  commodities  in  everyday  use,  food, 
shelter,  clothing,  etc.  The  second  class  includes  a  few  objects  of 
direct  use  in  the  .satisfaction  of  wants,  for  example,  the  paintings 
of  an  artist  now  dead ;  but  it  mostly  consists  of  certain  primary  fac- 
tors in  production  derived  from  nature,  for  example,  ultimate  or 
primary  raw  materials  such  as  iron  and  copper,  the  services  of  land, 
and  water  powers.  The  former  of  these  two  classes  again  divides 
for  our  purpose  into  two  sub-classes:  increasing-cost  and  constant- 
cost  goods.  Accordingly,  we  shall  study  more  or  less  fully  the  supply 
schedules  of  three  types  of  goods:  (i)  Increasing-Cost  Goods; 
(2)  Constant-Cost  Goods;  and  (3)  Fixed-Supply  Goods. 


Costs  and  Supply  Prices 

The  most  obvious,  as  also  the  most  important,  fact  about  the 
normal  supply  schedules  of  producible  goods  is  that  the  supply  prices 
of  such  a  schedule,  that  is,  the  prices  on  which  depends  the  forth- 
coming of  supply,  are  fixed  by  costs  of  production,  including,  of 
course,  suitable  remuneration  for  such  contributions  as  are  made  by 
the  entrepreneur  himself.  If  a  certain  price  will  insure  to  the 
entrepreneur  that  he  will  get  back  the  money  he  has  put  into  a 
product  and  in  addition  will  get  a  reasonable  return  for  his  own 
direct  contributions,  he  will  surely  be  ready  to  furnish  the  product 
at  that  price.  Doubtless  he  would  be  glad  to  get  a  higher  price ;  and, 
under  some  conditions,  he  may  be  able  to  do  so.  But  that  fact  has 
no  relation  to  our  present  problem,  which  is  concerned  solely  with 
the  normal  supply  schedule — the  series  of  mutually  dependent  sup- 
plies and  prices.  What  price  will  be  necessary  to  secure  the  forth- 
coming of  a  given  supply?  or  what  volume  of  supply  will  follow 


XXV]  NORMAL  SUPPLY  SCHEDULES 

the  appearance  of  a  given  price? — these  are  the  questions  of  immedi- 
ate interest.  And  the  general  answer  is  that  the  price  which  will  be 
necessary  to  bring  forth  a  given  supply  is  that  price  which  equals 
the  greatest  cost  of  producing  said  supply,  supposing  differences  of 
cost  to  exist;  and  the  volume  of  supply  which  will  follow  the  ap- 
pearance of  a  given  price  is  that  volume  which  will  have  as  its  great- 
est cost  an  amount  equal  to  said  given  price. 

Test  of  a  Cost. — It  follows  from  the  relation  between  cost 
and  supply  prices  above  brought  out  that  one  method  of  testing 
whether  or  not  a  given  element  is  a  cost  is  to  see  whether  or  not  it 
appears  in  the  supply  price.  Supposing  competition  to  be  free,  does 
the  producer  insist  on  getting  a  price  higher  than  would  otherwise  be 
necessary  just  because  the  element  under  consideration  has  to  be 
supplied?  If  the  answer  is  "yes,"  that  element  is  certainly  a  cost;  if 
the  answer  is  "no,"  that  element  is  not  a  cost. 

II 
Theory  of  Cost 

Concerned  with  Entrepreneur's  Cost. — We  have  seen  that 
the  supply  prices  of  the  normal  supply  schedules  of  producible  goods 
;ire  quite  certain  to  be  in  general  the  costs  of  production.  But,  as 
there  is  considerable  room  for  misunderstanding  with  respect  to  the 
meaning  of  cost,  it  seems  necessary  to  make  some  more  specific  com- 
ments on  this  matter.  First,  it  is  important  to  note  that  the  costs 
with  which  we  are  here  concerned  are  costs  to  the  entrepreneur,  the 
person  or  persons  responsible  for  the  production  of  goods.  This 
obviously  grows  out  of  the  fact  that  we  are  interested  in  costs  as 
determinants  of  supply  prices,  and  supply  prices  are  the  prices  which 
the  entrepreneur  sets  up  as  necessary  to  the  forthcoming  of  supply.1 


1  There  is  a  good  deal  of  criticism  directed  against  the  prominence  piven 
by  most  economists  to  the  standpoint  of  the  entrepreneur.  This  criticism 
does  not  seem  to  me  justified.  The  entrepreneur  is  the  person,  natural  or 
legal,  who  undertakes  the  responsibility  of  production — decides  the  kind, 
amount,  and  method  of  production.  As  entrepreneur,  he  must  hold  the  place 
of  first  importance.  Perhaps  a  function  of  such  magnitude  ought  not  to  be 
delegated  to  private  persons  at  all ;  but  whoever  undertakes  this  task  neces- 
sarily holds  the  center  of  the  stage. 


PRINCIPLES  OF  ECONOMICS  [XXV 

Concerned  with  Immediate  Costs. — In  saying  that  we  are 
concerned  here  with  entrepreneur's  cost,  we  almost  of  necessity 
affirm  that  we  are  concerned  with  immediate  rather  than  ultimate  or 
intermediate  costs.  The  steel  which  a  producer  of  automobiles  buys 
as  raw  material  is  of  course  a  product,  and  so  has  its  own  cost  which 
indirectly  must  be  a  cost  of  the  automobiles.  In  turn,  the  factors 
necessary  to  the  producing  of  steel,  namely :  pig  iron,  coke,  etc.,  are 
products  having  their  costs,  which  costs,  therefore,  must  indirectly 
be  costs  of  the  automobiles,  remoter  costs,  intermediate  costs. 
Finally,  there  must  be  factors  beyond  which  we  cannot  go,  the 
original  raw  materials  given  by  nature,  the  earth  itself,  the  services 
of  laborers,  etc., — what  we  call  ultimate  or  primary  costs.2  But, 
though  there  are  costs  other  than  the  immediate  ones,  we  are  not, 
generally  speaking,  concerned  with  such  other  costs,  in  our  present 
connection.  To  this  it  is  necessary  to  make  the  one  exception  of 
primary  costs  incurred  by  the  entrepreneur  himself  and  not  to  be 
purchased  from  other  persons,  for  example,  the  risk  burden  of  the 
business. 

Money  Costs :  Explicit  and  Implicit. — The  largest  constituent 
in  entrepreneur's  cost  is  usually  direct  money  cost — the  money  out- 
lay for  factors  of  different  sorts  which  he  buys  on  the  open  market, 
for  example,  raw  materials,  fuel,  machinery,  labor,  the  use  of  capital, 
etc.  A  closely  allied  constituent  consists  of  the  money  value  of  such 
of  the  above  purchasable  factors  as  the  entrepreneur  himself  fur- 
nishes. Thus,  the  individual  entrepreneur  commonly  supplies  labor 
services  of  much  importance  which  he  might  purchase  on  the  open 
market.  Again,  in  almost  all  cases  he  is  obliged  to  put  in  some 
capital  of  his  own.  Further,  he  may  use  his  own  land,  instead  of  rent- 
ing from  someone  else.  Now,  for  his  labor  services,  he  will  naturally 
try  to  get  as  good  wages  as  he  would  have  to  pay  others  for  the 
same  services.  Similarly,  on  the  capital  which  he  put  in,  he  will  of 
course  insist  on  getting  the  usual  interest.  So,  for  the  use  of  his 
land,  he  will  expect  as  large  a  return  as  the  rent  which  he  would 


'The  former  designation  lays  stress  on  the  logical  finality  of  these  costs; 
the  latter  places  them  in  their  temporal  or  causal  order. 


XXV]  NORMAL  SUPPLY  SCHEDULES 


315 


have  to  pay  another  landlord.  Accordingly,  in  estimating  what  the 
product  costs  him,  he  will  make  allowances  for  all  these  items.  They 
will,  therefore,  constitute  a  part  of  the  cost  of  production, — quasi- 
money  costs,  we  might  call  them,  or  implicit  money  costs,  as  con- 
trasted with  his  direct  money  outlay  which  we  may  call  explicit  money 
costs. 

Cost  of  Entrepreneur's  Contribution. — We  have  just  re- 
marked on  two  constituents  of  entrepreneur's  cost,  explicit  and  im- 
plicit money  costs.  There  is  still  a  third  which  must  not  be  ignored. 
In  addition  to  the  various  contributions  often  made  by  the  entrepre- 
neur which  he  might  buy  from  others, — implicit  or  quasi-money 
costs, — there  is  another,  one  corresponding  to  his  distinctive  func- 
tion as  entrepreneur.  Some  person  natural  or  legal  must  undertake 
the  responsibility  of  deciding,  willing,  that  production  shall  go  for- 
ward, else  of  course  there  will  be  no  production.  This  distinctive 
function  of  the  entrepreneur  is,  therefore,  a  factor  in  production. 

But  the  fact  that  the  distinctive  contribution  of  the  entrepre- 
neur is  a  necessary  factor  in  production  is  not  sufficient  to  make  it 
an  element  in  cost.  In  order  to  be  such  an  element,  it  must  also  be  an 
economic  factor,  a  factor  having  an  economic  character,  having  value. 
But  the  question  whether  this  factor  has  an  economic  character  is  not 
so  easily  determined  as  in  the  case  of  the  other  factors  which  have 
been  considered.  Just  because  the  services  of  labor,  of  capital,  and 
of  land  are  purchasable  on  the  open  market,  we  have  no  difficulty 
deciding  whether  or  not  they  have  value,  for  that  is  evidenced  by 
the  prices  at  which  they  are  bought  and  sold.  The  distinctive  func- 
tion of  the  entrepreneur,  on  the  contrary,  cannot  thus  be  bought  and 
sold.  The  assumption  of  final  responsibility  and  a  certain  residue 
of  management  cannot  be  separated  from  the  ownership  of  the  busi- 
ness, hence  cannot  be  delegated  to  anyone  else,  cannot  be  hired  from 
anyone  else,  therefore  cannot  be  bought  and  sold,  so  cannot  have  a 
price  to  prove  its  economic  character.  It  follows  that  we  can  ascer- 
tain whether  or  not  this  factor  in  production  has  economic  value  and 
so  is  a  true  economic  factor,  only  by  finding  that  at  the  margin  the 
total  return  to  undertakings  has  a  money  value  in  excess  of  all  costs 
of  the  kinds  already  enumerated,  that  is,  explicit  and  implicit  money 


316  PRINCIPLES  OF  ECONOMICS  tXXV 

costs.  In  short,  business  in  general  must  yield  a  profit,  if  the  dis- 
tinctive services  of  the  entrepreneur  are  to  be  accounted  as  having 
value,  hence  as  being  economic  factors,  and  therefore  as  entering 
into  the  cost  of  production. 

Meaning  of  Profit. — But  at  this  point  it  becomes  quite  im- 
portant to  avoid  a  possible  misunderstanding  as  to  the  meaning  of 
this  word  profit.  Profit  is  the  implicit  price  of  those  services  of  the 
entrepreneur  which  are  peculiarly  his  own,  distinctive  of  his  office. 
We  do  not  have  a  profit,  in  the  strict  sense,  just  because  we  have  a 
return  in  excess  of  the  money  outlay,  the  explicit  money  cost.  Such 
an  excess  would  very  likely  be  necessary  to  cover  the  wages  due  the 
entrepreneur  as  a  laborer  or  to  cover  the  interest  due  him  as  having 
supplied  a  portion  of  the  capital.  The  excess  in  return  which  spells 
profit  must  go  beyond  the  implicit,  as  well  as  the  explicit,  money 
cost.  Thus,  a  small  merchant  investing  $2,000  and  clearing  $1,600 
a  year  from  the  business  might  be  thought  of  as  getting  80  per  cent 
on  his  investment;  when  in  fact  $1,300  out  of  the  $1,600  was  the 
wages  of  his  labor  as  manager,  salesman,  etc.,  while  $120  was  interest 
on  his  $2,000  at  6  per  cent ;  so  that  his  true  profit  was  only  $180  or  9 
per  cent. 

Profit  a  Part  of  Cost. — That  this  peculiar  contribution  of  the 
entrepreneur,  or  the  profit  representing  that  contribution,  is  at  the 
present  time  a  true  cost  of  production  can  scarcely  be  doubted,  and 
is  seldom  denied  by  economists.3  Generally  speaking,  the  prices 
of  products  are  high  enough  to  insure  that  entrepreneurs  shall  get  a 
return  in  excess  of  all  money  costs,  explicit  and  implicit.  During 
the  late  war,  most  governments,  when  making  contracts  for  supplies 
and  when  taxing  business,  assumed  that,  as  a  matter  of  course,  pro- 
ducers must  be  allowed  to  make  from  ten  to  fifteen  per  cent  gross 
profit  or  five  to  ten  per  cent  net  profit — profit  in  excess  of  interest. 
It  seems  to  follow  that,  in  the  opinion  of  practical  men,  true  profit 
commonly  is,  and  in  fact  must  be,  an  element  in  cost. 


3  Some  economists  hold  that  profit  would  not  continue  to  exist  as  a  cost 
under  a  static  set  of  conditions.  Some  even  hold  that  this  element  is  not  a 
part  of  cost  at  present.  For  comments  on  some  arguments  in  support  of 
this  opinion,  see  Note  4  in  the  Appendix. 


XXV]  NORMAL  SUPPLY  SCHEDULES  317 

Interpretation  of  Profit. — We  have  seen  that  profit  forms  a 
necessary  element  in  the  cost  of  production :  the  supply  price  of  a 
commodity — the  price  necessary  to  bring  out  the  marginal  units  of 
supply — must  be  great  enough  to  include  a  profit  to  the  entrepreneur 
as  well  as  to  cover  the  other  items  which  have  been  enumerated.  This 
topic,  profit,  must  not,  however,  be  passed  without  a  further  word 
of  explanation  as  to  how  the  word  is  to  be  interpreted.  There  has 
been  from  the  first,  and  continues  to  be,  considerable  confusion  in 
economic  writing  in  respect  to  the  proper  method  of  computing  profit. 
Even  business  practice  is  not  wholly  uniform,  though  the  interpre- 
tation which  will  here  be  given  is  probably  the  generally  accepted 
one.  Profit  proper  should  be  computed  on  the  basis  of  the  capital 
invested,  not  on  the  basis  of  the  outlay.  Thus,  let  us  suppose  that 
$50,000  is  invested  in  a  given  business ;  that  this  business  yields  an 
annual  output  of  100,000  units;  that  the  cost  per  unit — profit  not 
included — is  $4 ;  and  that  the  rate  of  profit  proper  required  is  8  per 
cent.  Under  these  conditions,  the  producer  does  not  say:  "Since 
each  unit  of  product  costs  me  $4,  and  since  8  per  cent  of  this  is 
$.32,  I  will  supply  the  commodity  in  question  for  $4.32" ;  instead, 
he  says:  "Since  I  have  in  the  business  an  investment  of  $50,000, 
since  8  per  cent  on  this  is  $4,000,  and  since  the  other  costs  equal  $4 
per  unit,  I  will  supply  the  commodity  at  $4  plus  $4,000  divided  by 
100,000  units,  that  is,  for  $4.04."  4 

Rent  Commonly  a  Part  of  Cost. — In  the  above  account  of 
entrepreneur's  cost,  it  was  more  than  once  implied  that  such  cost 
includes  rent,  that  which  is  paid  for  the  use  of  land  unmodified  or 
modified  only  by  such  improvements  as  are  practically  irremovable 
and  indestructible.  We  seem  to  be  justified  in  doing  this,  in  view  of 
the  precise  nature  of  the  problem  before  us :  What  are  the  elements 
included  in  the  cost  of  the  individual  entrepreneur  ?  For,  from  this 


4  This  of  course  does  not  mean  that  producers  would  not  be  glad  to  get 
the  larger  profit  reached  by  the  former  method  of  computation.  If  they 
are  regulated  by  government  and  have  to  get  the  consent  of  government  in 
fixing  their  price,  they  often  try  to  induce  the  regulator  to  adopt  the  method 
of  reckoning  which  gives  the  larger  profit.  But  where  competition  is  free, 
producers  will  in  the  long  run  offer  to  supply  the  commodity  provided  the 
price  is  high  enough  to  give  them  a  profit  on  the  capital  actually  invested. 


318  PRINCIPLES  OF  ECONOMICS  [XXV 

standpoint,  rent  must,  in  the  great  majority  of  cases,  be  looked  on 
as  a  part  of  cost.  The  reason  for  this  is  that,  in  the  great  majority 
of  cases,  a  given  piece  of  land  may  be  put  to  many  different  uses, 
and  the  individual  entrepreneur  will  be  obliged  to  compete  against 
other  entrepreneurs  who  want  that  land  for  other  purposes,  just  as 
he  would  be  obliged  to  compete  against  them  for  labor  services  or 
capital  services.  That  is,  rent  would  participate  in  determining  the 
entrepreneur's  supply  price  just  as  truly  as  wages  or  interest. 

Disutility  or  Pain-Cost  Not  Included. — One  or  two  further 
comments  will  complete  this  long  discussion  of  cost  of  production. 
First,  we  note  that  entrepreneur's  cost,  as  above  described,  does  not 
in  the  main  include  what  is  often  called  psychic  or  disutility  cost. 
What  this  sort  of  cost  means  is  best  seen  in  the  case  of  labor.  While 
to  the  entrepreneur  the  cost  of  labor  is  his  money  outlay  for  that  labor, 
to  the  man  who  supplies  it,  the  cost  of  that  labor  may  be  the  dis- 
comfort, weariness,  lack  of  leisure,  which  supplying  the  labor  in- 
volves; that  is,  he  may  think  of  these  as  constituting  the  sacrifice 
which  he  is  making  when  he  furnishes  the  labor.5  Some  writers, 
indeed,  have  insisted  that  this  is  the  only  cost  which  deserves  the 
name.  It  is  the  true,  the  real  cost  of  production,  they  say.  Doubt- 
less such  a  view  of  the  matter  has  some  point;  but  it  is  not  sound 
doctrine  in  our  present  connection.  We  are  here  concerned  with 
supply  prices,  and  are  interested  only  in  those  costs  which  influence 
the  entrepreneur  in  fixing  his  supply  prices.  But,  these,  obviously, 
must  be  his  own  costs,  his  own  sacrifices,  not  those  of  the  persons 
from  whom  he  purchases  particular  contributing  services.  But  his 
costs,  in  the  case  of  the  contributing  services  of  other  persons,  are 
plainly  the  sums  of  money  which  he  pays  for  those  services.  When 
we  come  to  consider  the  principles  governing  the  prices  of  the  pri- 
mary factors  of  production,  those  factors  behind  which  we  cannot  go, 
such  as  the  original  raw  materials,  the  uses  of  the  earth's  surface, 
labor  services,  etc.,  we  shall  find  that,  with  some  of  these,  disutility 
does  play,  or  may  play,  a  part  in  determining  their  prices.  In  that 


8  The  laborer  may,  however,  have  in  mind  the  fact  that  he  can  get  wages 
from  some  other  employer.  In  that  case  we  have,  not  a  psychic  or  disutility 
cost,  but  an  opportunity  cost. 


XXV]  NORMAL  SUPPLY  SCHEDULES  319 

part  of  our  study,  therefore,  we  shall  have  to  recognize  the  influ- 
ence of  disutility.  But  in  our  present  connection  it  is  of  interest 
to  us  only  in  so  far  as  it  determines  the  attitude  of  the  entrepreneur 
himself, — that  is,  his  attitude  in  settling  what  reward  is  necessary  to 
compensate  him  for  the  peculiar  sacrifices  incident  to  his  position  as 
entrepreneur,  in  other  words,  what  profit  he  must  insist  on  having. 

Prices  of  Cost-Goods  Constant. — Another  comment  which 
needs  to  be  made  in  this  connection  is  that  from  the  standpoint  of 
normal  price,  the  prices  of  cost-goods,  materials,  labor,  etc.,  are  as- 
sumed to  be  constant,  fixed.  We  conceive  the  entrepreneur  as  look- 
ing over  the  field  and  saying  to  himself :  I  shall  have  to  pay  so  much 
for  a  place  of  business,  so  much  for  material,  so  much  for  labor, 
so  much  for  the  use  of  borrowed  capital,  and  so  on.  In  addition, 
I  must  get  something  for  the  capital  and  labor  which  I  myself  put 
in ;  and,  as  I  am  not  in  the  business  for  my  health,  I  must  get  some- 
thing more  for  my  trouble  and  risk,  that  is,  I  must  have  a  profit. 
From  these  data,  he  computes  what  he  must  fix  upon  as  his  supply 
price.  In  doing  this,  he  assumes  the  fixity  of  the  prices  of  those 
goods  and  services  which  he  has  to  buy.  Of  course,  he  knows  that, 
as  a  matter  of  fact,  those  prices  are  not  finally  fixed,  that  they  are 
liable  to  change  even  during  the  productive  process.  But,  roughly 
speaking,  they  do  not  change.  As  a  totality,  they  are  fairly  well  fixed 
for  the  period  of  time  with  which  he  is  concerned.  Further,  it  is 
just  his  business  to  assume  the  burden  of  taking  the  inevitable  risk 
of  such  changes.  That  risk  he  in  part  covers  by  adding  something 
to  his  supply  price;  while  at  the  same  time  he  makes  another  addi- 
tion to  that  supply  price,  in  order  to  provide  compensation  to  himself 
for  taking  the  chances  involved. 

ILLUSTRATIVE  PROBLEMS 

i.  "Wages  are  the  remuneration  of  the  laborer  for  the  sacrifices 
which  he  has  to  make  in  supplying  labor  services.  It  is  ridiculous  to 
call  them  a  cost  of  production." 

Is  there  any  reason  why  we  should  not  say  that  wages  are  at  once 
a  cost  and  a  remuneration? 


320 


PRINCIPLES  OF  ECONOMICS  [XXV 


2.  To  one  laborer,  on  account  of  poor  health,  the  day's  work  in  a 
particular  factory  will  mean  much  greater  disutility  than  it  means  to 
another  laborer  in  the  same  factory.     Will  this  difference  affect  the  sup- 
ply price  of 'the  commodity  produced  at  the  factory? 

3.  A  tailor  carrying  on  business  in  a  small  town  tells  a  prospective 
customer  from  Detroit  that  he  can  make  him  clothes  more  cheaply  than 
an  equally  good  Detroit  tailor  because  his  costs  are  lower,  mentioning 
among  other  things  the  rent  of  the  site  where  his  shop  is  located.     Can  he 
legitimately  treat  rent  as  a  cost  in  this  case?     Defend  an  affirmative 
answer. 

4.  A  railway  lawyer  is  trying  to  prove  before  a  court  that  a  pro- 
posed 2  cents  per  mile  passenger  rate  is  unjust  to  his  road  in  that  it  will 
not  permit  paying  a  reasonable  profit,  say  6  per  cent,  on  the  investment. 
He  admits  that  this  rate  will  be  realized  on  the  physical  equipment  of  the 
road,  valued  at  $5,000,000;  but  argues  that  the  company  has  to  provide 
for  a  pay-roll  of  $50,000  every  month  and  ought  to  earn  profits  on  this  as 
well.     Now  this  claim  may  or  may  not  be  reasonable.     It  all  turns  on 
whether  providing  for  this  pay-roll  involves  .  .  .  Finish  the  sentence. 

Ill 
The  Normal  Supply  Schedules  of  Increasing-Cost  Goods 

We  have  seen  that  the  supply  prices  of  the  normal  supply 
schedules  of  producible  goods  are  in  general  costs  of  production.  But 
producible  goods  are  not  all  of  one  kind.  As  noted  in  the  begin- 
ning of  this  chapter,  we  distinguish  at  least  two  different  classes  of 
such  goods  in  studying  their  normal  price,  increasing-cost  goods  and 
constant-cost  goods ;  and  the  supply  prices  which  cost  gives  to  these 
different  sorts  of  goods  are  quite  different.  We  take  up  first  "in- 
creasing-cost goods."  The  general  character  of  these  goods  was 
brought  out  in  Chapter  XI.  The  larger  the  amount  of  these  goods  we 
try  to  produce,  the  greater  will  be  the  cost  of  the  additional  units  of 
product.  In  other  words,  the  larger  the  amount  produced,  the  greater 
will  be  the  marginal  cost  of  production.  But  the  cost  of  producing 
any  particular  part  of  output  determines  the  supply  price  of  that 
part  of  output ;  hence  the  marginal  supply  price  must  rise  with  every 
increase  in  the  output.  As  a  result,  the  normal  supply  schedule  of 
increasing-cost  goods  must  be  of  the  sort  earlier  called  typical, — sup- 


XXV]  NORMAL  SUPPLY  SCHEDULES  321 

ply  varying  directly  with  price  and  vice  versa.  The  table  and  dia- 
gram given  for  a  typical  market  supply  schedule  on  page  270  would, 
therefore,  illustrate  well  enough  the  normal  supply  schedules  of  in- 
creasing-cost goods.  With  every  rise  in  price,  supply  increases ;  with 
every  fall  in  price,  supply  diminishes. 

IV 
The  Normal  Supply  Schedules  of  Constant-Cost  Goods 

The  second  class  of  producible  goods  with  which  we  have  to  deal  is 
constant-cost  goods.  By  these  we  mean  goods  the  output  of  which 
can  be  increased  from  a  very  small  to  a  very  large  amount — so  large 
as  compared  with  the  natural  range  of  demand  that  it  may  be  called 
indefinitely  large — without  substantial  change  in  the  cost  of  produc- 
tion. Emphasis  is  laid  on  "substantial,"  since  it  is  probable  that  any 
change  in  the  volume  of  output  can  seldom  be  effected  without  some 
change  in  cost.  But,  in  the  case  of  a  host  of  manufactured  com- 
modities, the  degree  of  change  in  cost  necessary  to  effect  a  given 
change  in  the  volume  of  output  is  practically  negligible.  Thus,  only 
under  quite  exceptional  conditions  would  the  cost  of  producing  the 
numberless  articles  supplied  by  five-  and  ten-cent  stores  be  increased 
by  any  ordinary  increase  in  the  amount  supplied.  Doubtless  it  is 
possible  to  have  in  mind  periods  of  time  so  long  that  decided  changes 
in  cost  prices  would  take  place.  But  normal  price,  from  its  very 
nature,  is  not  concerned  with  periods  of  such  length.  The  very  idea 
or  normality  implies  constancy  with  respect  to  the  principal  condi- 
tions ;  for,  without  such  constancy,  there  would  be  no  price  which 
tended  to  prevail  throughout  the  whole  period,  that  is,  there  would 
be  no  normal  price. 

The  character  of  the  normal  supply  schedule  of  goods  of  this 
sort  is  easily  seen.  By  hypothesis  there  is  no  change  in  cost  over  a 
wide  range  of  output.  It  follows  that  these  goods  have  but  one  supply 
price.  At  any  price  below  this  one,  no  supply  will  be  forthcoming; 
at  this  price,  an  indefinite  amount  will  be  available;  and,  at  higher 
prices,  no  more  will  appear,  since  the  amount  at  the  one  price  is  in- 
definitely large.  It  follows  that  the  supply  schedule  of  constant-cost 
goods  takes  the  following  form :  At  prices  below  the  one  supply  price. 


322  PRINCIPLES  OF  ECONOMICS  [XXV 

supply  is  zero ;  at  the  one  price,  supply  is  indefinitely  large  or  varies 
within  the  range  specified  in  the  hypothesis ;  and,  at  prices  above  the 
one,  supply  remains  at  the  same  indefinite  figure  as  at  the  one  price. 
Such  a  schedule  is  given  in  the  first  2  columns  of  the  table  on  page  333. 

Output  Adjusted  to  Demand. — One  peculiarity  of  the  supply 
schedule  of  this  particular  type  of  producible  goods  seems  to  call 
for  special  comment.  This  is  the  statement  that,  at  the  one  supply 
price,  supply  is  indefinitely  large.  Now  this  account  of  the  matter 
must  not  be  interpreted  as  meaning  that  producers  actually  get  out 
and  put  on  the  market  an  indefinitely  large  amount  of  the  product  in- 
volved. Supply  always  means  the  amount  sellers  stand  ready  to  dis- 
pose of  at  the  given  price;  and,  in  the  case  of  normal  schedules  for 
producible  goods,  standing  rea^y  does  not  necessarily  involve  that 
the  given  volume  is  actually  produced  if  the  given  price  is  reached. 
Producers  stand  ready  to  go  this  far,  but  have  time  to  experiment 
with  the  situation  and  of  course  will  not  effect  such  production  unless 
they  are  warranted  in  doing  so  by  the  actual  demand  conditions.  If 
they  cannot  usually  market  the  goods  they  will  not  produce  them, 
though  their  supply  price  has  been  reached.  The  appearance  of  their 
price  is  not  alone  sufficient  to  insure  production.  The  volume  of 
product  is  consciously  adjusted  to  the  actual  demand. 

V 
The  Normal  Supply  Schedules  of  Fixed-Supply  Goods 

The  preceding  section  was  occupied  with  the  consideration  of  the 
supply  schedules  of  producible  goods.  We  now  take  up  the  schedules 
of  goods  which  are  strictly  non-producible  or,  for  some  reason,  behave 
as  if  they  were  of  this  sort.  They  may  be  goods  of  which  the  stock 
is  fixed,  like  the  land  on  the  earth's  surface,  or  goods  having  a  regular 
output  but  one  which  is  fixed,  like  the  annual  uses  of  land  as  a  site 
or  as  a  something  on  which  a  crop  can  be  raised.  The  former  we 
might  call  fixed-stock  goods ;  the  latter,  fixed-output  goods.  We  here 
designate  them  fixed-supply  goods,  because,  as  will  appear  in  a  mo- 
ment, the  situation  makes  their  normal  supply  constant  and  so  makes 
this  a  characteristic  mark  for  them  all. 


XXV]  NORMAL  SUPPLY  SCHEDULES  323 

Supply  Price  Anything  above  Zero. — We  may  take  as  one 
of  the  most  important  of  these  fixed-supply  goods,  the  uses  of  land 
just  mentioned.  Thus,  within  the  area  of  a  given  city,  there  are  just 
so  many  sites,  say  10,  of  a  certain  degree  of  desirability  for  busi- 
ness purposes.  Broadly  speaking,  no  human  action  can  increase  or 
diminish  their  number.  From  the  standpoint  of  normal  price,  what 
will  be  their  supply  schedule?  Doubtless  their  market  schedule 
would  present  itself  as  similar  to  the  one  given  on  page  270.  That 
is,  the  number  offered  would  vary  directly  with  the  price.  But  the 
situation  for  the  normal  schedule  is  different.  Normal  price  is  not 
concerned  with  momentary  tendencies  as  is  market  price,  but  with 
tendencies  covering  a  period  of  some  length,  a  period  long  enough  to 
eliminate  uncertainty  with  respect  to  real  values  and  the  real  attitudes 
of  possible  buyers.  Now,  over  any  such  period,  the  attitude  of 
owners  will  be  that  all  the  uses  of  such  sites  must  be  marketed  at 
some  price — whatever  price  can  be  obtained.  The  site  uses  not  being 
produced,  the  owners  cannot  save  a  cost  of  production  by  withhold- 
ing them  from  the  market.  Those  owners  would  prefer  to  get  higher 
prices ;  but  anything  is  better  than  nothing.  Hence,  in  the  long  run, 
owners  will  offer  all  these  uses  of  sites  for  whatever  price  they  will 
bring. 

In  this  particular  case  of  sites,  there  is  another  consideration  which 
makes  the  period  necessary  to  bring  all  the  sites  on  the  market  a 
rather  short  one.  While  some  types  of  non-producible  goods  are 
capable  of  indefinite  preservation,,  hence  can  be  reserved  for  future 
use,  and  so  can  profitably  be  withheld  from  the  market  for  consider- 
able periods,6  nothing  of  the  kind  is  true  of  the  uses  of  a  site.  These 
cannot  be  preserved  at  all ;  they  are  absolutely  perishable, — live  but 
for  the  moment.  If  the  owner  of  a  site  does  not  sell  the  1920  use 
of  that  site  during  1920,  he  can  never  sell  it  at  all.  He  can  of  course 
sell  the  1921  use,  the  1922  use,  and  so  on;  but  the  1920  use  is  gone 
forever.  Doubtless,  in  the  process  of  bargaining  with  possible  ten- 
ants, it  may  be  of  advantage  to  owners  to  forego  the  opportunity  to 


"  Doubtless  the  owners  of  such  goods  will  not  carry  out  this  policy 
indefinitely.  The  risks  are  too  great ;  and  man,  being  mortal,  his  interest 
in  possible  future  gains  is  limited. 


324  PRINCIPLES  OF  ECONOMICS  [XXV 

dispose  of  some  of  the  uses  of  a  site.  But  the  operation  is  evidently 
an  expensive  one ;  and  will  not  be  engaged  in  to  an  indefinite  extent. 
From  all  this  it  follows  that,  in  this  case  of  the  ten  sites,  the  supply 
of  uses  will  be  just  ten  at  every  price: — the  supply  will  be  a  fixed, 
unchanging,  supply.  Accordingly,  the  normal  supply  schedule  of 
these  sites  would  read  as  in  the  accompanying  table :  10  offered  when 
the  price  is  $12,000;  10  offered  when  the  price  is  $11,000;  10  offered 
when  it  is  $10,000 ;  and  so  on. 

Cases  Among  Producible  Goods. — To  get  a  perfect  case  of 

fixed-supply  goods,  we  chose  a  special  kind  of  non-producible  goods, 

the  annual  uses  of  land.     We  find,  how- 

PRICE  SUPPLY    ever    that  cases  of  this  sort  arise  among 

ooo  No.  OF  .        . 

DOLLARS  SITES     producible  goods.     Thus,   the   designation 

12  fixed-supply  goods  is  obviously  applicable  to 

I0  I0       goods  which  were  produced  by  some  one  no 

9  IO       longer  living.    Another  case  is  supplied  by 

7  10       goods  which  have  gone  out  of  fashion.  Such 

6  10       goods  can,  literally  speaking,  still  be  pro- 

I0       duced ;  but,  not  being  longer  wanted,  they 
3  10       will  not  be  produced, — they  are  economic- 

j  I0       ally  non-producible.    A  much  more  impor- 

•9  10       tant  case  is  that  of  some  agricultural  prod- 

I0  uct  between  two  harvests.  Thus,  roughly 
speaking,  our  stock  of  wheat  cannot  be  in- 
creased from  the  end  of  the  1920  harvest  to  that  of  the  1921  harvest ; 
so  that,  during  this  period,  the  supply  could  not  be  extended  beyond 
the  existing  stock.  On  the  other  hand,  the  prospect  of  a  new  crop 
putting  in  an  appearance  usually  insures  that  the  whole  existing 
stock  will  pass  into  supply  during  the  current  year.  Thus,  the  nor- 
mal supply  for  the  year  is  identical  with  the  existing  stock,  and  so 
that  supply  is  a  fixed  one. 

It  is  plain  that  these  later  cases  of  fixed-supply  goods  fulfil  the 
condition  from  which  their  designation  is  derived  much  less  per- 


T  Remember  that  wheat  is  a  fixed-supply  good  only  when  we  are  looking 
at  it  for  the  brief  period  between  two  harvests.  Over  a  longer  period,  it  is 
an  increasing-cost  good,  having  its  price  determined  by  a  different  law- 


NORMAL  SUPPLY  SCHEDULES  325 

fectly  than  the  one  first  chosen  for  illustration.  They  do,  however, 
fulfil  that  condition  in  a  sufficiently  large  measure  to  merit  the 
designation.  In  the  process  of  price  determination,  they  behave,  in  a 
general  way,  as  do  the  strictly  non-producible  goods.  It  should  be 
added  that  cases  of  this  sort — quasi -fixed-supply  goods  we  might  call 
them— are  likely  to  appear  temporarily  in  quite  unexpected  places,  in 
connection  with  all  sorts  of  goods.  But  these  will  more  naturally 
receive  comment  in  a  later  connection. 


CHAPTER  XXVI 


In  the  two  preceding  chapters  we  have  discussed  normal  demand 
schedules,  with  the  significances  to  consumers  which  lie  back  of 
them,  and  normal  supply  schedules,  with  the  costs  of  production 
which  in  two  cases  lie  behind  these.  It  is  through  these  normal 
demand  and  supply  schedules  that  the  normal  prices  of  goods  are 
determined. 

We  are  now,  therefore,  in  a  position  to  take  up  the  di- 
rect study  of  those  principles  which  are  commonly  given  as  govern- 
ing normal  price. 

We  shall  treat  in  succession  the  three  classes  of  goods  the  supply 
schedules  of  which  were  studied  in  the  last  chapter,  taking  them  up 
in  reverse  order, — fixed-supply  goods,  constant-cost  goods,  and  in- 
creasing-cost goods.  By  this  process  we  prepare  ourselves  to  handle 
almost  every  case  of  normal  price  determination;  for  the  three 
classes  of  goods  named  have  their  normal  prices  determined  in  three 
different  ways,  and  those  three  ways  include  practically  all  the  ways, 
and  indeed  quite  all  the  most  important  ones,  in  which  normal  price 
can  be  determined. 

Speaking  generally,  we  may  say  that  the  goods  of  the  first  class 
have  their  prices  determined  from  the  demand  side  only — through 
the  prices  of  the  demand  schedule;  that  goods  of  the  second  class 
have  their  prices  determined  from  the  supply  side  only — through 
the  prices  of  the  supply  schedule;  and  that  those  of  the  third  class 
have  their  prices  determined  by  elements  from  both  demand  and 
supply — through  the  prices  of  both  the  demand  and  the  supply 
schedules. 

We  begin  with  that  class  the  prices  of  which  are  determined 
from  the  demand  side  only. 

326 


XXVI]  NORMAL  PRICE  DETERMINATION  327 


Normal  Price  of  Fixed-Supply  Goods 

We  will  take  as  an  example  of  fixed-supply  goods  copies  of  the 
Basel  edition  of  Sir  Thomas  More's  Utopia.  Suppose  that,  at  about 
the  same  time  in  the  year  1925,  three  or  four  finds  are  made,  bring- 
ing on  the  market  a  new  supply  of  these  books  amounting  to  ten 
copies.  Suppose,  further,  that  the  demands  of  libraries  and  private 
collectors  are  such  that  the  aggregate  demand  schedule  is  as  follows  : 
i  copy  wanted,  if  price  is  $200;  2  copies,  if  price  is  $175;  4  copies, 

if  $160;  6  copies,  if  $125  ;  10,  if  $100;  n,  if 

a,  .£<*.  i  TTJJ.U  DEMAND     PRICE  SUPPLY 

$90;  14,  if  $75;  and  so  on.     Under  these  DOLLARS 

conditions,  what  must  the  price  tend  to  be,          i  200          10 

and  what  principles  will  regulate  that  price  ?  J^o 

The    accompanying    demand    and    supply          6  125           10 

schedule  shows  that  the  price  could  not  be        *°  :^ 

above  $100;  for,  if  it  went  above  this  figure,         14  75           i° 

4  buyers  would  withdraw,  making  demand        *0  50 

deficient,  and,  in  order  to  guard  against  this 

result,  the  sellers  would  bring  price  down  to  $100.  On  the  other  hand, 
price  could  not  go  down  to  $90;  since,  if  it  did  one  new  buyer  would 
come  in,  making  demand  excessive,  a  result  which  $ioo-buyers  would 
have  to  guard  against  by  bidding  price  up  to  at  least  $91.  Actual 
price,  then,  must  tend  to  be  some  price  between  $91  and  $100, 
inclusive. 

The  first  and  most  obvious  comment  on  this  case  is  that  our 
familiar  law  of  supply  and  demand  is  still  operative.  A  price  must 
be  reached  at  which  demand  and  supply  are  equal.  If  demand  and 
supply  were  not  quite  equal  at  one  of  the  prices  given  in  the  schedule, 
the  necessary  equating  would  be  effected  in  practice  by  compromise 
prices  between  those  given.  Equality  of  demand  and  supply  would 
be  reached  at  $95  or  $94  or  $97  or  at  some  other  figure  between  $90 
and  $100.  Further,  it  is  manifest  that  the  law  of  supply  and  de- 
mand is  regulating  not  merely  market  price  but  normal  price  also. 
The  market  price,  under  this  law,  would  in  successive  hours  or  days 
or  weeks  probably  run  both  above  and  below  $100,  perhaps  mostly 


328  PRINCIPLES  OF  ECONOMICS  [XXVI 

above.  But  under  the  same  law,  as  a  final  resultant,  a  normal  price 
of  $100  would  be  affirming  itself. 

We  have  noted  that,  in  this  case  of  fixed-supply  goods,  the  law 
of  supply  and  demand  is  still  operative  and  is  determining  normal 
price. 

It  may  be  worth  while  to  add  that  the  law  may  here  be  af- 
firmed in  a  somewhat  special  sense.  Since  supply  is,  by  hypothesis, 
constant  and  so  demand  must  do  all  the  changing,  and  since  supply 
is  in  the  long  run  identical  with  stock,  we  are  justified  in  restating 
the  principle  as  follows :  In  the  case  of  fixed-supply  goods,  the  nor- 
mal price  must  tend  to  be  that  price  or  some  one  of  that  series  of 
prices  which  will  cause  demand  to  become  equal  with  the  unchanging 
supply.  Or,  more  briefly,  the  normal  price  must  tend  to  be  that  one 
or  at  least  some  one  of  that  series  which  will  equate  demand  to 
stock. 

In  seeking  a  deeper  knowledge  of  the  processes  by  which  nor- 
mal price  is  determined,  the  natural  procedure  is  to  note  first  the  re- 
lations between  the  price  which  is  necessary  to  equate  supply  and 
demand  and  the  particular  supply  prices  and  the  particular  demand 
prices  which  are  the  immediately  effective  ones  in  the  regulation  of 
price.  These,  we  remember,  are  the  marginal  demand  price  and 
the  first  extra-marginal  supply  price  for  the  upper  limit  of  price  and 
the  marginal  supply  price  and  the  first  extra-marginal  demand  price 
for  the  lower  limit.  Are  all  of  these  operative  in  the  case  of  fixed- 
supply  goods,  and  if  not,  which  ones  are?  The  answer  is  quickly 
given:  Only  the  demand  price  limits  are  operative. 

As  we  saw  in  our  first  analysis  of  the  Utopia  example,  at  least 
one  reason  why  normal  price  could  not  be  above  $100  is  that,  unless 
price  is  as  low  as  $100,  the  last  increment  of  demand  will  not  appear 
at  all,  and  sellers,  therefore,  will  be  obliged  to  bid  actual  price  down 
to  $100  to  insure  disposal  of  the  stock.  That  one  of  the  two  variables 
fixing  the  upper  limit  of  price  which  comes  from  demand,  the  mar- 
ginal demand  price,  is  thus  actually  operative.  But  the  other  variable 
fixing  this  limit,  the  one  which  comes  from  supply,  is  not  operative. 
Sellers  are  not  compelled  to  bid  price  down  in  order  to  prevent  the 
appearance  of  a  new  supply ;  for  there  is  no  new  supply  to  appear 
— supply  is  constant.  In  other  words,  the  first  extra-marginal  sup- 


XXVI]  NORMAL  PRICE  DETERMINATION  329 

ply  price  has  no  share  in  fixing  the  upper  limit  of  actual  price.  That 
limit  is  fixed  by  the  marginal  demand  price  only.1 

Turning,  now,  to  the  lower  limit  of  price  of  this  same  com- 
modity, it  is  evident  that  actual  price  could  not  go  down  to  $90  be- 
cause this  would  make  demand  increase  by  one  copy,  thus  compelling 
buyers  to  bid  price  up  to  some  higher  figure  in  order  to  exclude  this 
increment  of  demand.  But,  on  the  other  hand,  buyers  do  not  have  to 
hold  price  up  in  order  to  keep  in  the  marginal  supply;  for,  by  hy- 
.pothesis,  supply  is  constant  and  therefore  will  not  fall  with  a  de- 
clining price.  In  short,  that  one  of  the  variables  fixing  the  lower 
limit  of  price  which  comes  from  demand — the  first  extra-marginal 
demand  price — is  the  only  one  actually  operative.  From  this 
analysis,  it  follows  that,  in  the  case  of  fixed-supply  goods,  the  normal 
price  must  be  one  of  the  prices  ranging  from  a  limit  fixed  by  the 
marginal  demand  price,  and  that  only,  down  to  a  limit  fixed  by  the 
first  extra-marginal  demand  price,  and  that  only. 

The  above  formula  confines  itself  to  defining  the  limits  within 
which  normal  price  must  tend  to  fall.  But,  as  already  noted,  actual 
demand  schedules  for  most  commodities  are  continuous, — show 
changes  in  the  volume  of  demand  for  practically  every  change  in 
price.  In  consequence,  the  marginal  and  the  first  extra-marginal  de- 
mand prices  will  be  in  juxtaposition  and  therefore  actual  price  can- 
not go  below  the  marginal  demand  price  at  all  without  reaching  the 
first  extra-marginal  demand  price.  In  practice,  then,  it  will  usually 
be  sufficient  to  define  normal  price  by  one  of  these  limiting  moments, 
the  marginal  demand  price.  Hence  the  following  formula: 

Principle.  Generally  speaking,  the  normal  price  of  a 
fixed-supply  commodity  must  tend  to  coincide  with  its  mar- 
ginal demand  price. 

The  formula  just  given  makes  the  marginal  demand  price  the 
decisive  factor  in  determining  the  normal  price  of  fixed-supply  goods. 
But  as  was  explained  in  Chapter  XXIV,  the  marginal  demand  price 
must  usually  be  an  expression  of  the  marginal  significance  to  the 
marginal  buyer,  as  estimated  by  himself,  of  the  quantity  of'  a  com- 


'The  limit  is  the  first  price  above. 


330  PRINCIPLES  OF  ECONOMICS  [XXVI 

modity  he  proposes  to  buy;  and  this,  in  turn,  must  be  determined 
by  his  estimate  of  the  marginal  utility  he  expects  to  derive  from  that 
quantity  of  the  commodity.  Further,  the  marginal  significance  or 
utility  to  the  marginal  buyer  is  the  general  marginal  significance  or 
simply  the  marginal  significance.  And,  finally,  in  any  formula  con- 
taining the  phrase  "marginal  demand  price,"  we  can  substitute  the 
phrase  "marginal  significance"  or  the  phrase  "marginal  utility." 
Hence  the  following  formula: 

Principle — The  Marginal   Significance  or  Utility   Principle. 

Generally  speaking,  the  normal  price  of  a  fixed-supply 
commodity  must  tend  to  be  that  price  which  expresses  the 
marginal  significance  or  utility  of  the  existing  stock  of  said 
commodity. 

ILLUSTRATIVE  PROBLEMS 

1.  During  the  current  year,  there  came  on  the  market  from  various 
sources  twelve  specimens  of  a  certain  rare  object.     If  the  ultimate  de- 
mand schedule  proves  to  be  as  follows :  i  wanted  at  $60 ;  2  more  at  $55 ; 
4  more  at  $50 ;  5  more  at  $45 ;  6  more  at  $40 ;  etc.,  what  price  will  in  the 
long  run  tend  to  be  reached?     Prove. 

2.  In  a  certain  year  the  output  of  wheat  proved  to  be  2,000  millions 
of  bushels.     The  ultimate  demand  schedule  for  the  year  ensuing  till  the 
next  harvest  was  as  follows:  1,600  million  bushels  wanted  if  price  were 
$1.30;  1,800  millions  if  price  were  $1.25;  2,000  millions  if  $1.20;  2,200 
millions  if  $1.15;  and  so  on. 

(a)  What  price  would  tend  to  prevail   for  that  year?     Prove  in 
detail. 

(b)  What  would  determine  it? 

(c)  What  price  would  tend  to  prevail  if  the  demand  moved  up  a 
step,  making  the  schedule  1,800  millions  at  $1.30;  2,000  millions  at  $1.25; 
2,200  at  $1.20;  2,400  at  $1.15;  and  so  on? 

(d)  What  price  if  demand  moved  up  two  steps,  making  the  sched- 
ule: 2,000  millions  at  $1.30;  2,200  at  $1.25;  and  so  on? 

(e)  What  price  if  demand  moved  down  two  steps,  making  the  sched- 
ule:  1,200  millions  wanted  at  $1.30;   1,400  millions  at  $1.25;    1,600  at 
$1.20;  1,800  at  $1.15;  2,000  at  $1.10;  and  so  on? 


XXVI]  NORMAL  PRICE  DETERMINATION  33! 

3.  "In  1348-49  the  black  death  carried  off  from  one-third  to  one- 
half  of  England's  workingmen.  In  consequence  wages  greatly  ad- 
vanced." 

(a)  Explain  the  advance  in  wages  on  the  basis  of  the  Law  of  Sup- 
ply and  Demand  given  on  page  286,  constructing  for  the  purpose  im- 
aginary demand  and  supply  schedules. 

(b)  Explain  the  advance  in  wages  on  the  basis  of  the  Marginal 
Significance  principle  given  above. 

(c)  Discuss  this  statement:     "Wages  rose  because  the  demand  for. 
the  laborers  who  were  left  had  greatly  increased." 

I'- 
ll 

Normal  Price  of  Constant-Cost  Goods 

In  sharp  contrast  with  the  class  of  goods  just  considered,  fixed- 
supply  goods,  are  the  constant-cost  goods  with  which  we  now  deal. 
The  former  had  no  supply  price,  or  perhaps  better,  their  supply 
price  was  indeterminate.  Constant-cost  goods,  on  the  other  hand, 
have  just  one  supply  price.  Within  the  limits  of  the  demand  likely 
to  develop,  an  indefinitely  large  supply  will  be  forthcoming  at  that 
one  price,  while  none  will  be  forthcoming  at  any  lower  price.  As  a 
hypothetical  example  of  this  class  of  goods,  we  will  take  the  wooden 
chair  used  in  the  fifth  problem  on  page  159.  This  chair  is  a  con- 
stant-cost good  at  the  single  price  of  30  cents,  so  long  as  demand 
is  not  less  than  500,000  and  not  greater  than  $2,000,000.  That  is, 
a  price  as  high  as  30  cents  is  necessary  to  bring  out  any  supply  at 
all,  since  this  is  the  cost  of  production ;  and  this  price  will  bring  out 
a  supply  indefinitely  large  as  compared  with  demand. 

The  law  of  normal  price  for  this  case  is  easily  derived.  As  we 
found  in  Chapter  XXIII,  the  limits  of  price  variation  may  be  fixed 
by  two  prices  from  the  demand  side,  or  by  two  prices  from  the 
supply  side,  or  by  some  combination  of  these.  But,  in  this  particular 
case,  the  operation  of  supply  prices  in  fixing  these  limits  is  so  de- 
cisive that  demand  prices  may  be  ignored  altogether.  There  is  but 
one  price  which  supply  conditions  will  permit  to  exist;  that  one, 
therefore,  must  prevail.  This  results  from  the  fact  that  in  this  case, 
the  limits  fixed  by  the  marginal  and  first  extra-marginal  supply 
prices  coincide.  Our  chair  will  not  be  supplied  at  all,  unless  the  price 


332  PRINCIPLES  OF  ECONOMICS  [XXVI 

is  as  high  as  30  cents;  and  any  additional  chairs  wanted  will  be 
forthcoming  as  long  as  this  price  is  offered.  The  former  condition 
insures  that  actual  price  cannot  be  lower  than  30  cents;  the  latter 
insures  that  it  cannot  be  higher  than  30  cents.  It  is  thus  rigidly  fixed  at 
this  one  point.  The  normal  price  of  such  a  commodity  must  tend  to  co- 
incide with  the  single  supply  price  without  respect  to  demand  prices.2 

The  principle  just  brought  out,  the  exclusive  dependence  of  con- 
stant-cost goods  on  the  supply  price,  is  so  important  that  it  seems 
best  to  give  it  the  benefit  of  ample  illustration.  We  take  for  this 
purpose  our  wooden  chair.  The  accompanying  table  shows  the 
single  supply  schedule  for  amounts  between  500,000  and  2,000,000, 
and  several  hypothetical  demand  schedules.  Strictly  speaking,  our 
supply  schedule  should  show  but  one  price.  But,  since  producers 
who  are  ready  to  supply  any  amounts  between  500,000  and  2,000,000 
at  30  cents  will  of  course  be  ready  to  furnish  these  amounts  at  any 
higher  price,  we  can  without  inaccuracy  set  down  these  figures  for 
supply  at  the  higher  prices  of  the  demand  schedules;  and,  since  this 
procedure  will  contribute  to  convenience,  it  is  adopted  in  the  table. 

Combining,  now,  supply  schedule  S  with  demand  schedule  A,  it 
is  plain  that  price  must  tend  to  be  just  30  cents.  Price  could  not  be 
higher  than  this;  since  sellers,  being  ready  to  supply  much  more 
than  the  total  amount  demanded  at  30  cents,  will  bid  down  to  that 
figure  in  order  to  get  as  much  of  the  market  as  possible.  On  the 
other  hand,  since  there  is  no  supply  forthcoming  at  prices  below  30 
cents,  buyers  will  bid  price  up  to  that  figure  to  insure  getting  what 
they  want.  Exactly  similar  reasoning  would  show  that  the  price 
must  necessarily  tend  to  be  just  30  cents  with  demand  schedule  B 
or  C  or  D  or,  in  fact,  with  any  one  we  could  imagine  which  made  de- 
mand at  30  cents  more  than  500,000  and  less  than  2,000,000. 

But  not  only  will  price  be  30  cents,  the  single  supply  price,  it 
will  rest  at  that  point  uninfluenced  by  demand  prices.3  The  most 


'  Of  course  this  does  not  mean  that  actual  price  can  be  emancipated  from 
all  relation  to  demand  prices.  Actual  price  could  never  be  higher  than  the 
marginal  demand  price.  But  this  simply  means  that,  if  the  marginal  demand 
price  were  not  as  high  as  the  single  supply  price,  the  commodity  in  question 
would  not  be  produced  at  all,  and  hence  the  problem  of  its  price  determination 
would  not  arise  at  all. 

3  Remember,  however,  the  qualification  already  noted. 


XXVI] 


NORMAL  PRICE  DETERMINATION 


333 


clearly  decisive  proof  of  this  assertion  is  to  be  found  in  the  fact  that 
the  same  price  would  be  reached  if  our  demand  schedule  were  so 
altered  as  to  put  the  demand  prices  which  might  influence  the  matter 
quite  outside  of  the  price  bound  to  prevail.  Thus,  let  us  suppose 
the  schedule  D  to  be  so  altered  that  from  50  cents  to  15  cents  there 
is  no  change  in  the  volume  of  demand.  Now,  under  this  schedule 
as  under  the  others,  normal  price  must  tend  to  rest  at  30  cents ;  buy- 
ers will  hold  it  up  to  this  point;  sellers  will  hold  it  down  to  this 
point.  But  with  a  normal  price  of  30  cents,  the  marginal  demand 
price  for  schedule  E  would  have  to  be  50  cents,  since  that  price  is 
low  enough  to  bring  in  the  whole  demand  actually  satisfied;  while 
the  first  extra-marginal  demand  price  would  have  to  be  15  cents, 
since  no  addition  to  demand  takes  place  till  this  price  is  reached. 
But  neither  of  these  prices  influences  a  price  set  at  30  cents.  A 
marginal  demand  price  of  50  cents  would  permit  actual  price  to  rise 
to  50  cents;  while  a  first  extra-marginal  demand  price  of  15  cents 
would  permit  actual  price  to  fall  as  low  as  20  cents.  But,  in  fact, 
actual  price  cannot  rise  above  30  cents,  nor  fall  below  30  cents.  Its 
position,  therefore,  is  uninfluenced  by  the  demand  prices. 


SUPPLY 

PRICE 

DEMAND  ooo 

Schedule 

S 

Schedule 

Schedule 

Schedule 

Schedule 

Schedule 

000 

Dollars 

A 

B 

C 

D 

E 

500-2000 

3 

2 

3 

3 

5 

5 

500-2000 

2 

10 

12 

15 

20 

20 

500-2000 

I 

50 

51 

60 

80 

80 

500-2000 

•75 

300 

500 

Sio 

IIOO 

IIOO 

500-2000 

•50 

500 

750 

IO2O 

1400 

1400 

500-2000 

.40 

6OO 

895 

1200 

1520 

1400 

500-2000 

•30 

7OO 

950 

1540 

1840 

1400 

o 

.25 

IOOO 

I2IO 

2OOO 

2560 

1400 

o 

.20 

1500 

I800 

256O 

2800 

1400 

o 

•  15 

2500 

3000 

3800 

4563 

2000 

We  are  now  in  a  position  to  observe  the  final  results  of  our  study 
of  constant-cost  goods.  These  goods,  we  have  just  shown,  must 
tend  to  have  a  price  coincident  with  their  single  supply  price,  un- 
influenced by  their  demand  prices.  But  that  single  supply  price,  a? 
we  learned  in  the  chapter  on  supply  schedules,  is  the  cost  of  pro- 


334  PRINCIPLES  OF  ECONOMICS  [XXVI 

duction  to  the  representative  producer;  and  demand  prices,  as  we 
learned  in  the  chapter  on  demand  schedules,  are  expressions  of  the 
marginal  significance  or  utility  of  the  commodity  to  marginal  con- 
sumers. 'Making  the  substitution  of  terms,  therefore,  we  may  say 
that  the  price  of  a  constant-cost  commodity  tends  to  coincide  with 
its  cost  to  representative  producers,  uninfluenced  by  the  significance 
or  utility  of  the  commodity  to  consumers.4 

The  result  of  the  preceding  discussion  has  been  to  set  up  cost 
of  production  as  the  determinant  of  the  normal  price  of  constant- 
cost  goods.  However,  a  word  of  caution  is  here  necessary.  The 
power  of  cost  to  determine  price  is  derived  from  its  power  to  in- 
fluence the  forthcoming  of  supply.  Its  influence,  therefore,  is  ex- 
ercised through  the  future  rather  than  the  past.  It  is  not  because 
the  existing  product  had  a  cost  that  price  has  to  equal  cost,  but  be- 
cause the  future  output  will  have  a  cost.  From  this  fact  it  results 
that  unless  there  is  call  for  future  production,  cost  can  have  no 
influence  on  price.  If,  for  example,  a  change  in  fashion  makes  the 
existing  stock  of  a  particular  style  of  shoe  in  excess  of  any  possible 
demand  at  a  price  as  high  as  cost,  there  will  obviously  be  no  need 
for  further  production,  and  so  cost  will  have  no  influence  on  the 
price.  Such  a  commodity  will,  as  seen  in  our  classification  of  com- 
modities, pass  into  the  class  of  fixed-supply  goods.  Its  price  will 
then  become  purely  a  matter  of  demand  prices  and,  therefore,  of  the 
forces  lying  behind  those  prices,  namely,  significance  or  utility.  To 
insure  our  recognition  of  this  point,  our  principle  will  explicitly  state 
that  the  continued  production  of  the  commodity  in  question  must  be 
called  for. 

Another  caution  is  suggested  by  the  consideration  on  which  the 
last  was  based, — that  cost  of  production  acts  only  through  its  re- 
lation to  future  product.  Cost  of  production  may  change,  rise  or 
fall ;  and,  after  every  change,  it  will  be  the  new  cost  which  must  de- 
termine price.  To  anticipate  this  difficulty,  some  writers  have  argued 
that  we  ought  to  say  "price  must  equal  cost  of  reproduction."  To 
this,  however,  the  answer  of  Cairnes  is  perhaps  sufficient:  All 
scientific  principles  assume  constancy  of  conditions ;  the  cost  of  which 


*  Remember  the  qualification. 


XXVI]  NORMAL  PRICE  DETERMINATION  335 

is  decisive  at  any  period  is  the  cost  of  that  period,  conditions  sup- 
posed to  be  unchanged.  But,  if  anyone  prefers,  there  is  no  serious 
objection  to  saying  cost  of  reproduction. 

The  principle  brought  out  in  this  discussion  may  now  be  formu- 
lated as  follows : 

Principle.  The  normal  price  of  constant-cost  goods, 
the  continued  production  of  which  is  demanded,  must  ap- 
proximately equal  their  cost  to  representative  producers. 

ILLUSTRATIVE  PROBLEMS 

1.  From  a  cement  factor  promoter  in  1901 :     "We  can  easily  satisfy 
any  fair-minded  person  that  our  proposition  is   a  veritable  gold  mine. 
Cement  can  be  put  on  the  market  by  a  well-equipped  mill  at  a  cost  of 
about  $1.75  a  barrel,  while  it  is  selling  for  $4,  thus  giving  a  profit  of 
over  100  per  cent.     With  the  supply  of  raw  material  practically  unlimited, 
our  mill  will  soon  be  turning  out  600,000  barrels  per  year,  and  our  annual 
profits  will  be  nearly  $1,500,000.     You  can't  afford  to  stay  out." 

Supposing  the  facts  to  be  as  stated,  what  economic  law  was  over- 
looked in  drawing  conclusions? 

2.  "Labor  once  spent  has  no  influence  on  the  future  value  of  any 
article." 

(a)  Show  that  this  is  true  as  applied  to  the  wooden  chair  which 
was  used  in  working  out  our  principle. 

(b)  Does  the  above  statement,  admitting  it'to  be  true,  invalidate  our 
principle? 

3.  At  a  certain  time  the  price  of  whiskey  in  this  country  was  about 
fifty  cents,  the   cost  of   producing   it.     The   United   States   government 
thereupon  levied  on  each  gallon  produced  a  tax  of  one  dollar.     What 
naturally  happened  to  the  price  of  whiskey?     Why? 

4.  "Let  us  suppose  that  five  or  six  concerns  are  supplying  the  build- 
ing brick  used  in  a  certain  district,  and  that  by  a  new  method  of  manu- 
facture they  manage  to  double  their  output  for  the  former  expenses  of 
labor.     What   will  happen   as   regards  the   price   of  brick?     From   our 
knowledge  of  what  competition  usually  does,   we  are   apt  to  say:  the 
price  of  brick  will  fall  50  per  cent.     This  may  be  the  final  result,  but  not 
necessarily  so.  ...  Manufacturers  in  normal  times  will  increase  their 
production  of  brick.  ...  To  take  off  the  extra  supply  of  brick  they  must 


336  PRINCIPLES  OF  ECONOMICS  [XXVI 

find  a  wider  circle  of  demand.  ...  It  may,  however,  happen — not  in  the 
case  of  brick  probably,  but  in  large  articles  of  limited  consumption — that 
there  is  no  such  circle  of  demand  at  lower  levels;  then  what  will  happen 
is  that  the  manufacturers  will  cut  down  their  output  to  the  same  quan- 
tity of  brick  as  before,  and  maintain  the  former  high  price.  ...  It  is 
contrary  to  all  experience  to  think  that  employers  will  voluntarily  raise 
wages  or  pay  higher  interest — because  costs  have  decreased.  They  only 
do  so  under  compulsion  of  fear  that  their  rivals  will  cut  the  feet  from 
under  them.  Where  competition  is  active  it  will  often  seem  as  though 
reduction  of  costs  were  almost  immediately  followed  by  fall  in  prices 
of  products,  but,  in  the  last  resort — and  that  is  what  concerns  us  in 
seeking  for  a  universal  law  of  value — the  new  prices  are  determined  by 
the  lower  and  wider  levels  of  want  which  are  ready  to  take  up  increased 
supply  of  the  majority  of  ordinary  commodities." 

The  above  quotation  is  taken  from  the  writings  of  an  able  economist. 
It  has  been  modified  at  a  few  points  to  eliminate  ambiguities.  I  think, 
however,  that  it  does  not  misrepresent  his  views.  In  any  case,  it  brings 
out  a  way  of  looking  at  the  matter  which  the  student  should  be  familiar 
with. 

(a)  State  clearly  what  is  the  precise  point  which  the  author  seems 
to  be  trying  to  make. 

(b)  Show  that  it  is  unsound. 

5.  A  certain  residence  in  Ann  Arbor  is  taxed  each  year,  let  us  say, 
$42,  of  which  sum  $12  is  properly  chargeable  to  the  land  while  the  re- 
maining $30  is  chargeable  to  the  house.  Under  the  operation  of  the  two 
principles  of  normal  price  which  we  have  now  had,  the  $30  will  really 
be  paid  by  the  tenant,  being  shifted  from  the  landlord  to  him,  while  the 
$12  will  not  be  shifted  and  so,  as  far  as  the  future  is  concerned,  will  re- 
main on  the  landlord.  Explain  how  it  is  that  things  come  out  this  way. 

Ill 
Normal   Price  of  Increasing-Cost   Goods 

Fixed-supply  goods,  we  have  found,  have  their  prices  determined 
by  demand  forces  only.  Constant-cost  goods,  on  the  other  hand, 
have  their  prices  determined  by  supply  forces  only.  But  in  the  case 
of  increasing-cost  goods  with  which  we  now  deal,  forces  from  both 
sides  participate.  This  grows  out  of  the  fact  that  the  supply  schedule 
is  of  the  sort  called  typical  in  our  first  account  of  these  schedules. 


XXVI]  NORMAL  PRICE  DETERMINATION  337 

Since,  by  definition,  the  cost  of  these  products  increases  as  the  out- 
put increases,  their  supply  schedule  will  show  a  change  in  supply 
for  every  change  in  the  supply  price.  But  general  demand  schedules, 
as  explained  in  Chapter  XXIV,  are  practically  always  of  the  typical 
sort,  showing  change  in  the  volume  of  demand  with  every  change 
in  price.  Hence  our  present  case  is  one  wherein  both  schedules  are 
of  the  regular  type.  In  consequence,  any  price  which  does  not 
equalize  demand  and  supply  sets  up  reactions  tending  to  displace 
that  price,  on  both  the  demand  side  and  the  supply  side;  and  these 
reactions  influence  the  determination  of  the  point  where  price  finally 
rests,  whether  they  come  from  the  side  of  demand  or  that  of  supply. 
Normal  price,  then,  for  increasing-cost  goods  is  determined  by  both 
demand  and  supply  forces. 

Perhaps  the  best  way  to  confirm  this  reasoning  is  to  show  by 
illustration  ( i )  that  every  variation  in  either  the  demand  schedule  or 
the  supply  schedule  would  cause  a  change  in  price,  and  (2)  that 
the  determination  of  the  new  price  would  have  been  influenced,  not 
by  the  changing  element  only,  but  also  by  the  one  which  remained 
constant.  The  first  point  may  be  seen  by  a  moment's  study  of  the 
accompanying  table,  which  gives  three  different  schedules  of  the 
typical  sort  on  each  side.  Whichever  ones  we  combine  at  the  outset 
(not  including  D'"  or  S'")  if  we  keep  the  supply  schedule  constant 
and  unite  with  it  a  different  one  of  the  demand  schedules,  a  new 
price  necessarily  emerges.  A  precisely  similar  result  is  reached  if 
any  one  of  the  demand  schedules  is  kept  constant  .and  a  different 
supply  schedule  combined  with  it. 

The  second  point  is  not  so  easily  seen,  but  is  no  less  certain. 
When  a  new  price  is  fixed  by  the  use  of  a  new  demand  (or  supply) 
schedule,  that  price  after  all  is  not  made  what  it  is  simply  by  this 
new  demand  (or  supply)  schedule — it  is  also  influenced  by  the 
schedule  which  was  kept  constant.  To  illustrate,  let  us  start  with 
two  combinations  both  of  which  give  a  price  of  55  cents,  namely, 
demand  schedule  D  with  supply  schedule  S,  and  the  same  demand 
schedule  with  supply  schedule  S'",  a  schedule  which  shows  supply 
unchanging  from  53  cents  to  57.  Let  us  now  substitute  demand 
schedule  D'  in  the  two  combinations  successively  and  note  the  differ- 
ent results.  The  first  experiment,  putting  D'  with  S,  causes  price 


338  PRINCIPLES  OF  ECONOMICS  [XXVI 


DEMAND,  000,000  oz.  SUPPLY,  000,000  oz. 


Schedule 

Schedule 

Schedule 

Schedule 

A   itn    r. 
CENTS 

Schedule 

Schedule 

Schedule 

Schedule 

D"' 

D" 

D' 

D 

S 

S' 

S" 

S'" 

230 

100 

230 

2IO 

60 

310 

330 

290 

20X) 

240 

200 

240 

22O 

59 

300 

320 

280 

280 

250 

2IO 

250 

230 

58 

200 

310 

270 

270 

260 

22O 

260 

240 

57 

280 

300 

260 

260 

260 

230 

270 

250 

56 

270 

290 

250 

260 

260 

24O 

280 

260 

55 

260 

280 

240 

260 

260 

250 

290 

27O 

54 

250 

270 

230 

260 

260 

260 

300 

280 

53 

240 

260 

22O 

260 

270 

270 

310 

2OO 

52 

230 

250 

2IO 

250 

280 

280 

320 

300 

5i 

22O 

240 

200 

240 

290 

200 

330 

310 

50 

2IO 

230 

IQO 

230 

to  advance  i  cent,  from  55  to  56.  The  second  experiment,  putting 
D'  with  S'"  makes  price  advance  2  cents,  from  55  to  57.  The 
obvious  reason  is  that,  in  the  latter  case,  unchanging  supply  left  to 
demand  alone  the  equalizing  of  demand  and  supply  and  so  price  had 
to  advance  two  full  steps ;  while,  in  the  former  case,  increasing  sup- 
ply made  possible  the  equalizing  of  demand  and  supply  I  cent  earlier, 
and  so  stopped  the  rise  of  price  at  one  step. 

We  have  seen  that  the  normal  price  of  increasing-cost  goods 
must  tend  to  be  one  which  is  influenced  by  the  forces  of  both  demand 
and  supply  and  so  by  all  four  of  those  moments  which  fix  the  limits 
of  price  variation,  namely,  the  marginal  and  first  extra-marginal 
demand  prices  and  the  marginal  and  first  extra-marginal  supply 
prices.  But  in  Chapters  XXIV  and  XXV  we  learned  that  the  de- 
mand prices  are  expressions  of  the  significance  or  utilities  of  the 
several  amounts  of  the  product  in  question,  while  the  supply  prices 
are  the  different  marginal  costs  of  production.  Hence  in  the  above 
statement  we  may  substitute  for  the  phrases  "demand  prices"  and 
"supply  prices"  the  words  "significances"  and  "costs."  In  short,  the 
prices  of  increasing-cost  goods  are  determined  by  both  significance, 
or  utility,  and  cost.  More  precisely  the  price  of  an  increasing-cost 
good  must  not  go  above  that  price  which  expresses  its  marginal 
significance  nor  up  to  one  which  equals  its  first  extra-marginal  cost, 
and  must  not  go  below  its  marginal  cost  nor  down  to  a  price  which 
expresses  its  first  extra-marginal  significance  or  utility. 


XXVI]  NORMAL  PRICE  DETERMINATION 


339 


If  we  assume  for  the  sake  of  convenience  that  both  the  demand 
and  supply  schedules  are  perfectly  typical  and  regular,  it  follows  that 
the  two  upper  limits  would  fix  the  same  price,  as  in  the  schedule  on 
page  281,  and  the  same  would  be  true  of  the  two  lower.  It  would 
then  leave  our  formula  still  adequate  if  we  were  to  omit  the  limit 
fixed  by  extra-marginal  significance  or  cost  and  say :  "The  price  of 
an  increasing  cost  product  must  be  one  which  approximately  ex- 
presses its  marginal  significance  or  utility  and  equals  its  marginal 
cost." 

Before  finally  accepting  this  formula,  however,  it  seems  desir- 
able to  make  some  comments  in  the  nature  of  cautions.  First,  in 
order  to  anticipate  an  objectionable  interpretation  which  some  have 
made,  it  is  perhaps  best  to  insert  the  word  "normal"  before  marginal 
cost.  The  marginal  cost  is  the  greatest  cost  at  which  production  is 
being  carried  on,  and  this  might  be  taken  to  mean  the  cost  to  pro- 
ducers who  are  quite  behind  the  times  in  methods  and  facilities  and 
are  perhaps  losing  money  but  have  no  other  alternative  than  going 
on  till  they  become  bankrupt.  But  actual  price  is  commonly  lower 
than  cost  to  such  producers ;  hence  the  formula  breaks  down.  The 
answer  is  that  such  persons  are  not  true  marginal  producers.  A 
marginal  producer  drops  out  if  price  falls  below  his  figure,  while 
the  persons  in  question  continue  whatever  the  price.  They  are  far 
within  the  margin,  or,  better,  are  wholly  abnormal  elements.  Not 
their  cost,  but  the  normal  marginal  cost,  determines  price. 

Another  point  calling  for  a  moment's  attention  is  the  following : 
If  either  or  both  of  the  schedules  considered  are  discontinuous,  price 
will  not  necessarily  coincide  exactly  with  either  marginal  significance 
or  marginal  cost.  But  it  will  be  in  so  far  fixed  by  both  of  these 
that,  on  the  one  hand,  it  must  not  go  above  the  marginal  significance 
nor  down  to  the  first  extra-marginal  significance ;  while,  on  the  other 
hand,  it  must  not  go  below  the  marginal  cost  nor  up  to  the  first 
extra-marginal  cost. 

Finally,  it  is  of  course  always  possible  to  argue  that,  in  making 
up  a  formula,  either  one  of  the  determinants  might  be  chosen  and  the 
other  one  omitted,  on  the  ground  that  either  implies  the  other.  But 
if  we  affirm  the  relation  of  price  to  either  factor,  making  no  men- 
tion of  the  other,  there  is  danger  that  we  shall  be  understood  to  mean 


340  PRINCIPLES  OF  ECONOMICS  [XXVI 

that  the  one  we  do  mention  is  alone  responsible  for  the  price,  to  the 
entire  exclusion  of  the  other.  So,  in  the  opinion  of  the  writer,  it  is 
unsafe  to  carry  the  ellipsis  further  than  we  do  in  the  formula  now  to 
be  stated. 

Principle.  The  normal  price  of  increasing  cost  goods, 
the  continued  production  of  which  is  demanded,  tends  to  be 
a  price  which  both  expresses  the  marginal  significance  of 
the  output  and  equals  its  normal  marginal  cost. 

ILLUSTRATIVE  PROBLEMS 

1.  Suppose  that  the  production  schedule  of  silver  reads  as  follows: 
At  a  marginal  cost  of  55  cents,  170  million  ounces  can  be  furnished;  at 
a  marginal  cost  of  56  cents,  175  millions  ounces;  at  57  cents,  180  millions; 
at  58  cents,  185  millions;  at  59  cents,  190  millions;  at  60  cents,  195  mil- 
lions; at  6 1  cents,  200  millions;  at  62  cents,  205  millions;  at  63  cents,  210 
millions ;  etc.     Suppose,  secondly,  that  the  demand  schedule  is  as  follows : 
1 60  millions  ounces  wanted,  if  price  is  65  cents;  165  millions,  if  price  is 
64  cents;  170  millions,  at  63  cents;  175  millions,  at  62  cents;  180  millions, 
at  6 1  cents;  185  millions,  at  60  cents;  190  millions,  at  59  cents;  195  mil- 
lions, at  58  cents;  200  millions,  at  57  cents;  etc. 

(a)  Make  out  a  table  giving  the  ultimate  demand  and  supply  sched- 
ules. 

(b)  What  must  price  tend  .to  be  ?    Prove. 

(c)  What  will  it  tend  to  be  if  demand  moves  up  two  steps,  becoming : 
170  millions  wanted  if  price  is  65  cents;  175  millions  if  price  is  64  cents; 
and  so  on.     Prove. 

(d)  What  determines  price  in  these  two  cases? 

2.  "At  the  present  time  (1896)  silver  is  being  produced  at  a  marginal 
cost  of  approximately  65  cents  per  ounce.     But  the  price  of  silver  is  in 
the  long  run  determined  by  its  marginal  cost.     Hence  it  is  ridiculous  to 
expect  that  the  adoption  of  free  coinage  by  the  United  States  will  raise 
the  price  of  silver,  as  measured  in  gold,  to  $1.29  per  ounce,  or  any  other 
figure  above  65  cents." 

Admitting  that  the  normal  price  of  silver  must  in  the  long  run  coincide 
with  marginal  cost,  still  the  above  conclusion  is  unsound.     Explain. 

3.  Suppose  the  production  schedule  in  Problem  I  to  be  changed  so 
as  to  read  as  follows :  At  a  marginal  cost  of  55  cents,  175  millions  ounces 


XXVI]  NORMAL  PRICE  DETERMINATION  341 

can  be  furnished;  between  55  cents  and  59  cents  no  change  is  possible; 
at  a  marginal  cost  of  59  cents,  500  millions  ounces  can  be  furnished;  at 
60  cents,  525  millions  ounces;  and  so  on. 

(a)  What  would  price  tend  to  be  when  the  demand  schedule  was 
the  same  in  Problem  i  (a)  ?     Prove. 

(b)  What  would  price  tend  to  be   if  the  demand  schedule  were 
moved  up  ?.s  in  Problem  i   (c)  ?     Prove. 

(c)  What  would  price  tend  to  be   if  the  demand  schedule  were 
moved  up  two  more  steps  so  as  to  begin:  180  millions  ounces  wanted  at 
65  cents?    Prove. 

(d)  What  is  the  point  to  be  made? 

4.  The  author  of  a  recent  textbook  in  Economics  expresses  himself 
on  the  relation  of  cost  to  price  in  this  vein :  In  the  case  of  reproducible 
goods,  "cost  of  production  seems  of  commanding  importance."  "In  fact, 
however,  marginal  efficiency  (utility)  is  the  real  determinant  of  price," 
"cost  of  production  adjusts  itself  to  this."  "There  is  an  abundance  of 
silver  below  the  surface  that  is  not  mined  because  it  will  not  pay;  if  the 
marginal  efficiency  or  value  of  silver  should  rise,  these  more  expensive 
grades  would  at  once  be  marketed  and  the  new  marginal  cost  of  produc- 
tion would  adjust  itself  to  the  price." 

(a)  Construct  a  sentence  running  parallel  to  the  last  one  quoted,  but 
exactly  reversing  the  roles  of  marginal  utility  and  marginal  cost,  whereby 
it  would  seem  to  be  proved  that  marginal  cost  really  determines  price 
while  marginal  utility  merely  adjusts  itself  to  price.     The  sentence  should 
start  out  something  like  this :     "Generally  speaking,  it  would  seem  as  if 
marginal   utility   chiefly   regulated  price.     In    fact,   however,   marginal 
cost  is  the  real  determinant;  marginal  utility  adjusts  itself  to  this.     Below 
the  present  demand  for  silver  there  are  numerous  layers  of  demand  which 
are  now  merely  potential  because  the  corresponding  utilities  are  below 
the  present  market  price;  if,  now,  the  marginal  cost  of  producing  silver 
should  fall,  and  so  the  price  should  fall,  these  lower  layers  of  demand, 
etc.  .  .  ." 

(b)  Show  that  both  the  original  quotation  and  our  substitute  are 
inadequate, — that  the  price  reached  in  the  former  case  is  influenced  by 
marginal  cost,  while  that  reached  in  the  latter  case  is  influenced  by  mar- 
ginal utility. 


CHAPTER  XXVII 

SPECIAL  CASES  OF  NORMAL  PRICE 

The  general  principles  governing  normal  price  have  been  brought 
out  in  the  preceding  chapter.  But  there  are  some  cases  of  a  rather 
unusual  character  which  call  for  special  treatment.  Some,  on  ac- 
count of  peculiar  complications,  are  not  provided  for  at  all  in  the 
foregoing  principles.  Others  could  be  fairly  covered  by  a  careful 
interpretation  of  those  principles ;  but,  because  of  certain  peculiarities, 
further  explanation  is  needed  to  guard  against  misunderstanding. 
In  still  other  cases,  there  is  reason  for  attempting  a  special  state- 
ment, because,  although  the  principles  already  laid  down  quite  plainly 
apply  to  them,  it  is  possible  for  various  reasons  to  go  deeper,  to  find 
some  more  ultimate  statement  of  the  process  whereby  price  is  de- 
termined. 

I 

Rare  Products 

A  very  interesting  special  case  is  that  of  produced  goods  which 
are  so  limited  in  possible  amount  that  they  behave  almost  like  non- 
producible  goods.  We  speak  of  them  as  rare  products.  Notable  ex- 
amples are  the  very  rare  metals,  such  as  radium,  iridium,  even  plat- 
inum. We  should  probably  have  to  count  in  the  same  class  various 
vegetable  products,  special  brands  of  tea,  tobacco,  or  wines. 

As  already  indicated,  the  distinguishing  mark  of  this  class  of 
goods  is  the  fact  that  the  total  possible  output  is  extremely  restricted 
as  compared  with  the  demands  at  very  high  prices.  In  consequence, 
increases  in  output  through  increased  expenditure,  though  they  can 
be  made,  are  practically  negligible.  Goods  of  this  sort  give  us  a 
production  or  supply  schedule  which  looks  something  like  a  regular 
increasing-cost  schedule.  In  fact,  however,  the  extreme  smallness 
of  increase  in  output  with  rise  in  price  differentiates  these  from  the 
typical  cases  such  as  we  had  in  silver.  The  accompanying  schedule, 

342 


XXVII] 


SPECIAL  CASES  OF  NORMAL  PRICE 


343 


an  imaginary  one  for  a  very  rare  brand  of  tea,  may  be  taken  as 
representative.  Every  considerable  increase  in  output  takes  place 
while  cost  is  still  quite  low,  and  after  cost  has  passed  $25  the  ad- 
ditions are  all  in  single  pounds  and  even  fractions  of  a  pound.  If 
this  supply  schedule  be  combined  with  the  demand  schedule  marked 
D,  a  price  of  $250  per  pound  results,  and  this  price  is  really  deter- 


DEMAND 
OOO  POUNDS 

PRICE 

DOLLARS 

SUPPLY 
OOO  POUNDS 

D" 

D' 

D 

S 

S' 

i 

6 

3 

500 

11.683888 

40 

2 

8 

5 

450 

11.683885 

25 

3 

10 

6 

400 

11.68388 

18 

5 

12 

8 

350 

11.68387 

15 

6 

13 

10 

300 

11.68385 

13 

8 

15 

12 

250 

11.6838 

12 

10 

18 

13 

200 

11.6835 

10 

12 

25 

15 

150 

11.683 

8 

13 

40 

18 

IOO 

11.682 

6 

15 

60 

25 

50 

11.680 

5 

18 

100 

40 

25 

11.675 

3 

25 

120 

60 

10 

11.650 

2 

40 

160 

IOO 

5- 

11.600 

I 

60 

180 

120 

4- 

11.500 

100 

200 

160 

3- 

11.350 

1  20 

500 

180 

2.50 

II.  IOO 

160 

700 

200 

2. 

10.800 

180 

1,500 

500 

1-75 

10.500 

200 

3,000 

700 

1.50 

9.900 

500 

10,000 

1,500 

1.25 

9- 

700 

15,000 

3,000 

I. 

7-7 

1,500 

20,000 

10,000 

•75 

6. 

3,000 

30,000 

15,000 

•50 

4. 

mined  in  just  the  same  way  it  would  be  if  the  possible  output  for 
each  year  were  absolutely  fixed  at  11,000  pounds, — by  the  marginal 
significance.  The  fact  that  the  output  can  be  increased  beyond 
11,000  pounds,  and  the  further  fact  that  in  the  end  the  price  actually 
coincides  with  the  marginal  cost  of  production,  have  really  nothing 
to  do  with  fixing  the  price  at  $250.  Marginal  significance  alone  is 
effective. 

This  contention  is  most  plainly  established  by  noting  the  effect 
of  raising  or  lowering  the  demand  schedule  and  seeing  how  the  re- 
sults differ  from  what  they  would  be  if  we  had  a  typical  case  of 


344  PRINCIPLES  OF  ECONOMICS  [XXVII 

increasing-cost  goods.  Thus,  when  demand  schedule  D',  represent- 
ing demand  as  having  advanced  two  steps  all  along  the  line,  is  com- 
bined with  the  supply  schedule,  price  also  advances  two  steps,  from 
$250  to  $350.  So  demand  schedule  D",  which  represents  one  re- 
sulting from  a  decline  of  two  steps  in  demand,  causes  the  price  also  to 
drop  two  steps,  from  $250  to  $150.  If  now  our  supply  schedule  had 
been  a  typical  one  wherein  supply  appreciably  increased  as  the  mar- 
ginal expenditure  increased — represented  in  schedule  S',  the  result 
would  have  been  quite  different.  Our  original  demand  schedule  D 
combined  with  this  new  supply  schedule  would  have  given  us,  as 
before,  a  price  of  $250.  But  the  change  to  D'  would  have  caused 
an  advance  in  price,  not  of  two  steps,  but  only  of  one,  from  $250 
to  $300.  So,  combining  D"  with  the  new  supply  schedule  would 
have  caused  a  drop  in  price,  not  of  two  steps,  but  only  one,  from 
$250  to  $200. 

The  reason  is  plain.  In  the  latter  case,  the  substantial  increase 
in  output,  as  price  rose  under  schedule  D',  brought  supply  and  de- 
mand together  at  an  earlier  price;  while  the  substantial  falling  off 
in  output,  as  price  fell  under  schedule  D",  brought  supply  and  de- 
mand to  equality  at  the  earlier  point.  With  the  original  supply 
schedule,  both  of  these  conditions  were  lacking.  The  increase  as 
price  rose  was  negligible,  the  decrease  as  price  fell  was  negligible. 
The  new  prices,  therefore,  were  fixed  without  respect  to  supply  or 
cost.  We  have  here  in  effect  a  fixed-supply  or  fixed-output  com- 
modity, the  price  of  which  is  determined  by  marginal  significance 
alone. 

II 

Joint-Cost  Products 

In  studying  not  a  few  producible  goods,  we  strike  a  complication 
due  to  the  fact  that  several  different  commodities  emerge  from  the 
same  productive  process.  Thus,  the  dairyman  simultaneously  and  by 
productive  efforts,  a  large  share  of  which  are  inseparable,  brings  into 
existence  milk,  butter,  cheese,  beef,  and  hides.  The  refining  of  pe- 
troleum yields  not  only  common  illuminating  oil,  kerosene,  but  also 
vaseline,  gasolene,  and  naphtha.  Again,  the  coal  tar  resulting  from 
the  distillation  of  coal  for  the  making  of  gas  gives  us  a  whole  line 


XXVII]  SPECIAL  CASES  OF  NORMAL  PRICE  345 

of  by-products,  including  various  drugs,  perfumes,  and  a  large 
number  of  dyes.  Now,  in  cases  like  these  it  is  impossible,  save  in 
very  small  measure,  to  isolate  the  share  in  the  cost  of  production 
which  is  properly  chargeable  to  each  of  the  several  products.  This 
being  true,  we  surely  cannot  apply  to  these  goods,  without  qualifica- 
tion, the  principle  laid  down  for  other  producible  goods. 

The  special  theory  needed  here  was  set  forth  by  Mill.  It  is  that 
the  price  of  each  of  the  individual  products  must  "be  such  as  to 
equalize  supply  and  demand  for  that  product;  while  the  money  value 
of  the  whole  group  of  products  must  equal  their  cost  of  production. 
In  consistency  with  the  modern  analysis  which  goes  behind  demand 
to  significance  or  utility,  we  should  change  the  first  part  of  this 
formula  to  read  "the  price  of  each  of  the  individual  products  must 
tend  to  be  that  price  which  expresses  the  marginal  significance  of 
the  quantity  of  that  particular  product  which  is  put  upon  the  mar- 
ket." The  second  part  of  the  formula  can  remain  unchanged. 

The  argument  in  support  of  this  principle  is  as  follows :  First, 
the  price  of  each  member  of  the  group  of  products  must  be  such  as 
to  express  its  marginal  significance,  because,  under  the  conditions 
given,  the  quantity  of  each  of  the  products  is  virtually  fixed,  and 
hence  it  comes  under  the  laws  of  fixed-supply  goods.  This,  of 
course,  does  not  mean  that  the  supply  of  each  commodity  is  literally 
unchanging;  but  that  its  changes  do  not  take  place  in  response  to 
conditions  which  affect  that  commodity  itself  only,  but  rather  in  re- 
sponse to  conditions  which  affect  all  the  commodities  of  the  group. 
When,  therefore,  the  price  of  any  one  of  them  is  in  process  of  de- 
termination, the  supply  of  that  one  is  virtually  fixed ;  and  hence  the 
principle  governing  its  price  is  the  one  which  governs  the  price  of 
fixed-supply  goods.  But  the  principle  in  question  makes  the  price 
of  these  goods  depend  upon  marginal  significance ;  and  so  marginal 
significance  governs  the  case  now  before  us. 

It  is  no  less  certain  that  the  prices  of  all  the  members  of  the  group 
must  be  such  that  the  sum  total  of  their  money  values  will  equal  their 
joint  cost  of  production.  This  result  is  bound  to  be  brought  about 
through  processes  already  thoroughly  familiar.  If  at  any  point  the 
sum  total  of  the  group  prices  should  rise  above  this  total  cost  of  the 
group  products,  capital  will  move  into  the  industry,  supply  all  along 


346  PRINCIPLES  OF  ECONOMICS  [XXVII 

the  line  would  increase,  marginal  significance  would  fall,  and  so 
prices  would  fall.  Conversely,  if  the  total  costs  were  not  covered  by 
the  total  values,  capital  would  withdraw  from  the  industry,  the  supply 
of  the  several  commodities  would  fall  off,  their  marginal  significance 
would  rise,  and  so  prices  would  rise.  Doubtless  this  readjustment 
would  be  much  more  complicated  and  hence  much  slower  than  in 
the  case  of  isolated  individual  products,  but  in  the  long  run  it  would 
inevitably  come  about. 

Principle.  The  price  of  each  member  of  a  group  of 
joint-cost  products  tends  to  be  that  price  which  expresses 
the  marginal  significance  or  utility  of  the  quantity  of  that 
particular  product  which  is  put  upon  the  market,  provided 
that  the  sum  of  the  money  values  of  all  products  of  the 
group  tends  to  equal  their  joint  cost  of  production. 

ILLUSTRATIVE  PROBLEMS 

1.  Enumerate  some  products  of  a  Michigan  farm  which  might  be 
thought  of  as  by-products. 

2.  Discuss  the  question  as  to  whether  the  transportation  between  De- 
troit and  Jackson  of  products  of  quite  different  types,  for  example,  coal 
and  dry  goods,  truly  gives  rise  to  a  case  of  joint-cost  products. 

3.  "The  recent  fall  in  the  price  of  cotton  is  largely  due  to  the  im- 
proved manufacture  and  (increased)  uses  of  cotton-seed  oil." — Marshall's 
Economics  of  Industry,  page  225. 

Explain  why  these  facts  should  tend  to  cause  a  fall  in  the  price  of 
cotton. 

Ill 

Diminishing-Cost  Goods 

If  the  wooden  chair,  the  output  schedule  of  which  was  presented 
in  Chapter  XXVI,  is  taken  in  the  earlier  stages  of  this  schedule,  it 
belongs  in  the  class  of  diminishing-cost  goods, — the  more  output 
producers  try  to  furnish,  the  smaller  is  the  cost  per  unit.  This  case 
we  sometimes  treat  as  a  third  subdivision  of  variable-supply  goods. 
The  general  principle  for  variable-supply  goods  that  price  tends 


XXVII]  SPECIAL  CASES  OF  NORMAL  PRICE  347 

to  equal  cost,  if  properly  interpreted,  is  really  adequate  here,  and 
proper  interpretation  only  requires  us  to  remember  that  the  cost  of 
production  meant  in  our  principle  is  the  cost  which  is  representative 
at  the  very  time  mentioned,  not  at  an  earlier  or  a  later  date.  Never- 
theless, as  this  case  is  one  of  unusual  practical  importance,  it  seems 
to  deserve  special  comment. 

The  theory  is  comparatively  simple.  So  long  as  the  demand  for 
commodities  of  the  type  considered  is  still  relatively  small,  persons 
producing  them  are  obliged  to  employ  expensive  methods  of  produc- 
tion ;  hence  cost  and,  so,  price  is  high.  Presently,  demand  shows 
a  large  increase,  and  in  consequence  producers  are  able  to  realize 
the  various  gains  of  large-scale  production,  with  the  result  that  cost 
and,  so,  price  is  greatly  diminished.  Accordingly,  if  we  wish  to 
look  at  the  period  which  includes  these  changes  as  a  totality  and 
state  the  law  which  governs  that  period  as  a  totality,  we  have  to 
say  that  price  tends  to  equal  the  lowest  of  the  costs  of  production. 
The  importance  of  this  law  is  best  seen  in  connection  with  the  theory 
of  investment.  In  the  earlier  stages  of  a  new  industry,  while  crude 
or  experimental  methods  are  being  employed,  price  is  so  high  that 
producers  who  intend  to  introduce  improvements  which  will  greatly 
reduce  cost  are  wont  to  anticipate  therefrom  enormous  profits,  and 
perhaps  attempt  to  attract  investors  by  representations  to  this  effect. 
But  investors  should  remember  that,  just  because  it  is  going  to  be 
possible  to  reduce  cost  of  production,  the  price  itself  is  bound  to  fall, 
and  the  great  profits  described  by  promoters  will,  in  all  likelihood, 
fail  to  be  realized. 

The  principle  may  be  succinctly  stated  as  follows : 

Principle.  The  price  of  diminishing-cost  goods  tends 
to  equal  their  cost  to  producers  working  on  the  largest  scale 
justified  by  the  existing  conditions  of  demand, — monopoly 
being  excluded. 

IV 

Fixed-Supply  Income-Bearers 

Another  special  case  is  furnished  by  the  fixed-supply  income- 
bearer,  for  example,  a  piece  of  land  rented  for  business  purposes. 


348  PRINCIPLES  OF  ECONOMICS  [XXVII 

First,  with  regard  to  income-bearers  in  general,  we  remark  that, 
between  their  prices  and  their  incomes  there  must  tend  to  prevail 
at  all  times  a  fixed  ratio  approximately  equal  to  the  current  rate  of 
interest.  When  the  rate  of  interest  on  money  loans  is  approximately 
5  per  cent  then,  between  the  price  of  an  automobile,  let  us  say,  which 
is  to  be  used  for  purposes  of  hire  and  the  net  money  income  derived 
from  that  automobile, — due  allowance  having  been  made  for  repairs, 
replacement,  labor  services,  and  so  on, — the  ratio  is  bound  to  be  ap- 
proximately 100  to  5  or  20  to  I. 

Now,  the  establishment  of  this  ratio  may  conceivably  be  brought 
about  in  either  of  two  ways:  (i)  the  price  of  the  automobile  hav- 
ing been  fixed,  the  income  may  move  up  and  down  till  it  settles  at 
a  figure  just  1/20  of  the  price  of  the  automobile,  or  (2)  the  income 
having  been  fixed,  the  price  of  the  automobile  may  move  up  and 
down  till  it  settles  at  a  figure  just  20  times  as  great  as  the  income. 
Which  will  it  be?  This  depends  surely  on  which  of  the  two  things, 
the  income  or  the  price  of  the  auto,  is  free  to  move,  and  so  able  to 
put  itself  in  the  required  relation  to  the  other.  With  a  commodity 
like  the  automobile,  the  one  which  must  do  this  is  surely  the  net 
income.  For  the  automobile  is  a  producible  good,  and,  as  we  have 
already  learned,  prices  of  producible  goods  must  approximate  their 
costs  of  production.  The  price  of  the  automobile,  therefore,  is  not 
free  to  move.  The  income,  however,  moves  with  perfect  freedom. 
If  the  net  incomes  derived  from  renting  automobiles  are  too  large 
considering  the  price  of  machines,  then  competition  will  increase,  and 
in  consequence  rentals  and  incomes  will  decline.  If  incomes  are  too 
small,  competition  will  lessen,  whereupon  rentals  and  incomes  will 
increase.  Accordingly,  we  may  say  of  a  producible  income-bearer, 
that  its  price  is  first  fixed  and  to  this  price  the  net  income  is  ad- 
justed.1 

Passing,  now,  fo  non-producible  income-bearers  such  as  land,  we 
find  ourselves  facing  a  very  different  problem.  No  element  of  cost 


1  The  student  must  remember,  however,  that  the  price  of  constant-cost 
goods  is  not  always  governed  by  cost.  A  necessary  condition  was  expressed 
in  the  phrase,  "the  continued  production  of  which  is  demanded,"  which  ap- 
pears in  the  formula  on  page  340.  Producible  income-bearers  at  times  pass 
into  the  status  of  non-producible  ones. 


XXVII]  SPECIAL  CASES  OF  NORMAL  PRICE  349 

is  here  in  operation.  Utility  or  significance  only  can  affect  price; 
and  the  particular  significance  which  affects  it  is  obviously  that  given 
off  by  the  land  for  a  certain  definite  time.  In  short,  the  first  thing 
to  be  fixed  is,  not  the  price  of  the  land  as  a  whole,  but  the  price  of 
a  year's  use  of  the  land,  its  income ;  which  income,  having  been  fixed, 
determines  in  some  way  the  price  of  the  land  itself. 

Here  again,  as  with  producible  income-bearers,  the  relation  be- 
tween the  price  of  any  income-bearer  and  its  income  is  fixed  in 
advance  2  by  the  existing  ratio  between  capital  in  general  and  the  in- 
come therefrom.  When  5  per  cent  is  the  prevailing  rate  of  interest, 
we  can  be  pretty  sure  that  the  net  yearly  income  of  a  piece  of  ground 
which  commands  a  price  of  $1,000  is  about  $50. 

In  this  respect,  then,  the  piece  of  ground  and  the  automobile  are 
alike.  But,  in  the  matter  of  the  causation,  as  we  said,  the  cases  are 
entirely  different.  The  income  of  the  machine  adjusts  itself  to  its 
price  or  cost ;  the  price  of  the  land  adjusts  itself  to  its  income.  We 
cannot  say:  The  land  is  worth  $1,000,  hence  its  net  income  must  be 
$50.  Rather,  we  must  say :  The  net  income  of  the  land  is  $50,  hence 
its  value  must  be  about  $1,000.  To  use  another  illustration,  sup- 
pose a  certain  building  site  regularly  yields  a  net  income  of  $100, 
and  that  the  current  rate  of  interest  on  long-time  loans  is  about  5 
per  cent.  Then,  the  price  of  the  site  will  tend  to  be  as  many  dollars 
as  .05  is  contained  in  100,  or  $2,000.  The  usual  procedure,  when  5 
per  cent  is  the  rate,  is  to  multiply  the  income  by  20,  which  gives 
the  same  result  as  dividing  it  by  .05.  If,  now,  we  put  into  formal 
shape  the  point  here  elaborated,  we  have  the  following: 

Principle.     The  price  of  an    income-bearing    property 
not  capable  of  duplication  tends  to  equal  the  sum  of  money 


1  This  is  not  to  say  that  the  income-bearer  in  question  has  no  weight  in 
determining  the  ratio  between  capital  in  general  and  the  income  therefrom. 
Doubtless  every  transaction  involving  an  exchange  of  present  wealth  for  the 
right  to  a  series  of  future  incomes  helps  somewhat  in  firing  the  rates  at 
which  all  such  exchanges  take  place.  But  as  we  have  already  seen,  the  price- 
making  forces  come  to  a  head,  so  to  speak,  in  a  particular  class  of  transactions, 
— those  which  are  marginal,  those  in  which  marginal  significance  or  marginal 
cost  or  both  are  determined.  Accordingly,  we  can  safely  treat  almost  any 
particular  transaction  of  the  kind  here  engaging  us,  as  one  to  which  is  being 
applied  a  ratio  of  exchange  already  determined  elsewhere. 


PRINCIPLES  OF  ECONOMICS  [XXVII 

which,  lent  at  the  current  rate  of  interest,  would  yield  « 
yearly  income  equal  to  the  net  yearly  income  of  the  said 
property. 

ILLUSTRATIVE  PROBLEMS 

1.  If  a  certain  mining  stock  pretty  generally  yields  a  net  income  each 
year  of  $54  per  share,  what  would  its  price  tend  to  be,  supposing  that 
the  usual  rate  of  return  expected  in  such  lines  of  industry  is  about  7 
per  cent?     Prove. 

2.  If  the  dividend  of  the  above  stock  fell  to  $37,  what  would  you 
expect  the  price  of  the  stock  to  become? 

3.  Suppose  you  are  considering  the  purchase  of  a  $100  government 
bond,  untaxed  and  paying  2  per  cent  interest.     What  price  could  you 
reasonably  pay,  if  the  rate  commonly  obtained  on  securities  of  this  grade 
was  1.9  per  cent?     Prove. 

4.  Here  is  a  piece  of  farm  land  which  regularly  yields  a  net  income 
of  $1,700.     What  would  its  price  tend  to  be  when  the  rate  of  interest  in 
such  lines  was  about  5.5  per  cent? 

5.  Here  is  a  site  in  a  large  city  which  yields  a  ground  rent  of  $51,000 
a  year.     Suppose  that  the  Henry  George  ideas  came  to  prevail  in  said 
city,  so  that  the  tax  on  the  site  named  is  fixed  at  93  per  cent  of  its  rent. 

(a)  What  would  the  price  of  the  site  tend  to  be  when  the  rate  of 
interest  was  about  5  per  cent? 

(b)  What  would  it  be  if  the  rate  of  taxation  were  raised  to  100 
per  cent,  the  rate  of  interest  remaining  5  per  cent  ? 

6.  Supposing  that  there  were  no  interfering  causes,  what  would  you 
expect  the  price  of  a  government  bond  bearing  2  per  cent  interest  to  do  in 
times  when  the  rate  of  interest  has  been  exceptionally  high  for  many 
months  ? 

7.  A  certain  building  site  regularly  yields  a  net  income  of  $300  a 
year.     This  fact  would  cause  it  to  have  what  market  value  when  the 
rate  of  interest  was  8  per  cent  ?    6  per  cent  ?    5  per  cent  ? 

8.  A  certain  automobile  which  is  hired  out,  regularly  yields  its  owner 
a  clear  income  over  all  expenses  of  about  $300  per  year.     With  interest 
at  6  per  cent,  this  fact  would  cause  the  car  to  have  what  market  value  ? 
Is  this  a  reasonable  problem? 


XXVII]  SPECIAL  CASES  OF  NORMAL  PRICE  351 

9.  An   automobile  costs  $1,200  and  lasts  only  three  years.     With 
interest  at  6  per  cent  and  with  6  per  cent  added  for  the  trouble  and  risk 
of  running  an  automobile  livery,  what  must  an  automobile  earn  during  a 
year  to  make  the  business  pay? 

10.  A  certain  building  site  is  worth  $22,000.     With  interest  at  6  per 
cent  what  surplus  over  other  expenses  must  any  business  located  on  the 
given  site  pay  in  order  to  make  the  use  of  the  site  for  that  purpose 
profitable  ?     Interpret  this  problem  so  as  to  make  it  a  legitimate  one. 
Interpret  it  so  as  to  make  it  an  illegitimate  one. 

>" 
V 

Price  Under  Monopoly 

As  we  have  emphasized  repeatedly,  our  discussions  of  price 
determination  assume  perfect  freedom  of  competition.  The  con- 
sistent distribution  of  topics  would  therefore  seem  to  require  that 
the  discussion  of  monopoly  should  appear  separate  from,  and  sup- 
plementary to,  the  treatment  of  price  in  general.  We  shall  not, 
however,  be  able  to  undertake  an  adequate  treatment  of  the  topic  in 
any  connection,  so  that  it  seems  best  to  touch  upon  some  of  its  most 
significant  features  here.  Moreover,  this  procedure  is  in  a  sense 
justified  by  the  fact  that  price-determination  under  monopoly  is  not 
a  process  entirely  different  from  those  already  described,  but 
merely  a  variant  from  them.  Monopoly,  as  it  were,  injects  into  the 
situation  a  new  condition  under  which  the  principles  already  noted 
as  operative  work  out  the  result. 

The  first  point  to  be  made  is  that,  in  respect  to  its  more  immedi- 
ate determination  of  price,  we  have  under  monopoly  merely  a  spe- 
cial case  of  fixed-supply  goods.  The  supply  of  the  monopolized  good 
is  a  fixed  one ;  but  this  fixedness  is  not  of  natural  origin,  is  not  due 
to  any  absolute  limit  nor  to  the  limit  of  our  capacity  to  produce. 
Rather,  the  monopolist  consciously,  arbitrarily,  limits  the  amount 
produced,  or,  at  any  rate,  the  amount  put  on  the  market.  It  follows 
that,  immediately  speaking,  the  law  governing  monopoly  price  is  the 
same  as  that  given  for  fixed-supply  goods.  The  normal  price  of 
goods  sold  under  the  condition  of  monopoly  must  be  one  which  ex- 
presses the  marginal  significance  or  utility  of  the  output.  The  only 


352  PRINCIPLES  OF  ECONOMICS  [XXVII 

qualification  needed  is  one  which  recognizes  the  artificial  nature  of 
the  limit  set.  We  might  then  restate  the  formula  as  follows :  The 
normal  price  of  monopoly  goods  tends  to  be  one  which  expresses  the 
margined  significance  of  the  supply  as  fixed  by  the  free  choice  of 
the  monopolist. 

The  second  point  to  be  noted  gives  us  a  more  fundamental  gov- 
erning principle, — a  principle  which  tries  to  define  the  normal  price 
of  monopolized  goods,  the  price  which,  in  view  of  all  the  circum- 
stances, including  "the  free  choice  of  the  monopolist,"  tends  to  be 
established.  The  use  of  the  word  "normal"  here  may  sound  strange ; 
for  it  is  probable  that  most  people  think  of  monopoly  and  the  monop- 
olist's free  choice  as  doing  away  with  all  normality  of  price, — as  fix- 
ing price  in  a  purely  arbitrary  way.  This,  however,  is  going  much 
too  far.  Monopoly  prices,  though  less  submissive  to  natural  laws 
than  competitive  prices,  are  not,  after  all,  entirely  free  from  such 
laws.  The  monopolist  is  coerced  by  conditions  in  fixing  his  prices, 
not  according  to  his  own  caprice,  but  in  conformity  with  certain 
broad  principles  over  which  he  has  no  control. 

In  the  first  place,  if  a  monopolist  puts  his  price  too  high,  he 
will  be  disappointed  in  finding  his  gains  smaller  than  they  would  be 
if  he  had  set  his  price  lower.  Thus,  suppose  that  petroleum  is 
a  monopolized  product,  and  that  a  section  of  its  demand  schedule  is 
as  follows:  1,900  million  gallons  wanted  if  price  is  9  cents;  2,500 
million  if  price  is  8  cents;  3,000  million,  if  7  cents;  4,000  million, 
if  6  cents.  Suppose,  further,  that  the  total  cost  per  gallon  is  4  cents, 
so  that  there  is  a  clear  profit  of  5  cents  per  gallon  if  the  selling  price 
is  9  cents;  of  4  cents  per  gallon,  if  price  is  8  cents;  and  so  on.  If, 
under  these  circumstances,  the  monopolist  fixes  the  price  at  9  cents, 
he  will  clear  $95,000,000,  whereas  at  8  cents  he  would  have  cleared 
$100,000,000.  What  he  gains  through  larger  profit  on  each  unit 
of  product  he  will  more  than  lose  by  diminishing  the  total  number 
of  units  sold. 

On  the  other  hand,  it  would  be  foolish  for  the  monopolist  to  go 
to  the  opposite  extreme  in  carrying  out  a  policy  of  lowering  price 
in  order  to  increase  demand.  Thus,  if  he  puts  the  price  down  to  7 
cents,  he  will  indeed  cause  demand  to  increase  from  1,900  millions 
to  3,000  millions;  but  the  lowering  of  profit  on  each  unit  will  more 


XXVII]  SPECIAL  CASES  OF  NORMAL  PRICE  353 

than  offset  this  gain  in  amount  sold.  His  net  profit  will  drop  to 
$90,000,000.  In  short,  the  self-interest  of  the  monopolist  will  dictate 
that  he  fix  on  the  price  which  insures  that  the  product  of  the  net 
profit  per  unit  output  into  total  output  is  the  highest  possible ;  and 
this  gives  us  the  general  principle  determining  normal  price  under 
conditions  of  strict  monopoly. 

Principle.  Broadly  speaking,  the  normal  price  of  any 
monopolized  commodity  tends  to  be  that  price  which  will 
secure  the  largest  net  return  to  the  monopolist. 

A  cursory  examintion  of  the  preceding  analysis  shows  plainly 
that  the  cause  which  hindered  the  monopolist  from  pushing  price 
upward  indefinitely  was  the  fact  that  as  price  rose  demand  fell  off, — 
in  other  words,  demand  was  elastic,  varying  inversely  as  price.  If 
demand  had  diminished  more  rapidly  with  increase  in  price,  the  price 
actually  established  would  have  been  still  nearer  cost  of  production. 
If  demand  had  changed  less  rapidly  with  increase  in  price,  price 
would  have  been  put  still  farther  above  cost  of  production.  Hence 
the  following: 

Corollary.  The  tendency  of  monopoly  price  to  rise 
above  the  competitive  normal  varies  inversely  as  the  elas- 
ticity of  the  demand  for  the  monopolized  commodity. 

It  obviously  follows  from  this  corollary  that  every  cause  which 
increases  the  elasticity  of  the  demand  for  a  given  commodity  dimin- 
ishes the  tendency  of  price  in  said  case  to  separate  from  the  com- 
petitive normal.  Thus,  the  appearance  on  the  market  of  a  com- 
modity which  can  be  used  as  a  substitute  for  some  monopolized  one 
diminishes  our  dependence  on  the  latter  and  so  makes  its  demand 
schedule  more  elastic. 

The  preceding  discussion  has  brought  out  the  general  principle 
governing  normal  price  under  monopoly.  But  it  is  possible  to  be  a 
little  more  specific  regarding  one  particular  type  of  monopoly  which 
has  much  prominence  in  our  day.  This  is  known  as  the  capitalistic 
monopoly, — one  which  owes  its  origin  to  the  control  by  the  monopo- 
list of  an  exceptional  volume  of  capital.  Such  a  condition  enables 


354  PRINCIPLES  OF  ECONOMICS  [XXVII 

a  man  or  group  of  men  to  attain  the  position  of  monopolist,  to  gain 
and  maintain  exclusive  control  of  output,  largely  because  it  enables 
them  to  produce  more  cheaply  than  rivals  and  hence  drive  them  out 
of  business.  But  it  is  plain  that,  to  succeed,  monopolies  of  this  sort 
must  keep  prices  fairly  low, — somewhere  in  the  neighborhood  of 
cost  to  outsiders;  since  otherwise  competitors  will  be  continually 
starting  up,  and  will  have  to  be  bought  out  at  considerable  cost  or 
driven  out  by  destructive  commercial  wars.  Formulating  this  point, 
we  have  the  following : 

Principle.  The  normal  price  of  goods  produced  by 
capitalistic  monopolists  tends  to  approximate  a  figure  not 
much  above  cast  of  production  to  outsiders. 

ILLUSTRATIVE  PROBLEMS 

1.  Suppose  the  demand  schedule  for  Milton's  autographs  to  be  as 
follows:  I  wanted  if  the  price  is  $200;  2  if  it  is  $175;  4  if  $150;  5  if  $!4O; 
8  if  $125;  9  if  $115;  12  if  $100 ;  13  if  $90;  15  if  $75;  20  if  $50;  and  soon. 

(a)  If  there  came  on  the  market  9  autographs,  what  price  would 
they  tend  to  have  under  free  competition  ? 

(b)  What  price  if  all  were  owned  by  one  man? 

(c)  Answer  the  same  questions,  supposing  the  number  of  autographs 
to  be  15. 

(d)  Answer  the  same  questions,  supposing  the  number  to  be  20. 

2.  When  the  United  States  Steel  Company  was  fully  organized,  many 
independent  producers  desired  the  Trust  to  join  with  them  in  raising  the 
prices  of  steel  products.     The  authorities  of  the  Trust,  however,  refused, 
thinking  it  expedient  to  maintain  the  old  level.    What  do  you  suppose 
was  the  reason? 

MISCELLANEOUS  PROBLEMS  IN  PRICE 

1.  There  come  on  the  market  eleven  specimens  of  a  certain  rare 
object  to  be  disposed  of  at  the  best  price  attainable.     If  the  demand  is  as 
follows :  I  wanted  at  $65 ;  2  more  at  $60 ;  4  more  at  $50 ;  5  more  at  $45 ;  6 
more  at  $40 ;  etc.,  what  price  will  tend  to  be  reached  ?     Prove.      '  -' 

2.  In  the  last  problem,  suppose  a  tax  of  $5  to  be  levied  on  each  speci- 
men sold. 


XXVII]  SPECIAL  CASES  OF  NORMAL  PRICE  355 

(a)  What  effect  on  price  would  be  produced? 

(b)  Who  would  bear  the  tax  in  the  end? 

3.  A  friend  of  mine  owns  in  a  Chicago  suburb  a  house  and  lot  which 
used  to  rent  for  $300  a  year.     Last  year  real  estate  in  his  neighborhood 
had  a  boom,  with  the  result  that  his  property  increased  in  value  $3,000. 
In  consequence  he  raised  the  rent  to  $480.    What  is  the  matter  with  the 
economic  doctrine  involved? 

4.  "If  the  state  should  inaugurate  the  policy  of  levying  on  the  livery 
business  a  lo-per-cent  income  tax,  the  value  of  all  plants  devoted  to  this 
business  would  necessarily  fall  off  10  per  cent."     Criticize. 

5.  "Every  owner  of  a  railroad,  of  a  patent,  of  a  book,  or  of  a 
(monopoly)  property  of  any  kind,  finds  that  he  makes  more  money  by 
putting  prices  down  to  figures  that  are  reasonable,  that  is,  to  figures 
which  correspond  to  the  values  to  the  buyers  of  the  things  sold,  than  by 
keeping  them  up  beyond  those  figures." 

(a)  Show  that  the  words  "which  correspond  to  the  values  to  the 
buyers  of  the  things  sold,"  are  useless  as  a  definition  of  "reasonable" 
prices.     (Try  to  think  of  some  object  which  has  a  price  greater  than  that 
one  which  would  express  the  value  of  the  object  to  buyers.) 

(b)  In  the  case  of  producible  goods,  what  price  is  commonly  con- 
sidered a  reasonable  one? 

(c)  When  "reasonable"  is  understood  this  way,  is  it  probable  that 
the  first  half  of  Stickney's  statement  is  true? 

(d)  Point  out  some  cases  of  monopoly  of  which  the  statement  can 
be  affirmed  with  a  fair  degree  of  accuracy. 

6.  "Analogous  arguments  .  .  .  might  be  made  with  regard  to  mu- 
nicipal railways,  lighting  companies,  and  water  companies.     These  are 
all,  for  one  cause  or  another,  of  a  monopolistic  character.     The  public 
enjoys  no  guarantee  of  fair  treatment  on  account  of  any  competition  that 
can  affect  them." — Adams'  Finance,  page  264. 

What  is  the  doctrine  with  respect  to  competitive  industries  which  is 
implied  in  the  last  sentence  of  the  quotation? 

7.  "When  the  demand  for  wheat  increases  so  as  to  exceed  the  ca- 
pacity of  the  best  land,  the  price  of  wheat  rises  .so  as  to  leave  an  excess 
or  surplus  over  cost  of  production,  and  this  surplus  is  driven  into  the 
hands  of  the  landowner  as  rent  by  the  natural  competition  of  tenants. 
But,  now,  the  high  price  of  wheat  leads  to  the  cultivation  of  inferior 


356  PRINCIPLES  OF  ECONOMICS  [XXVII 

soils,  which  increases  the  supply  of  wheat  so  as  to  satisfy  the  demand, 
and  thus  brings  the  price  of  wheat  back  to  its  old  place." 
Criticize  the  part  in  italics. 

8.  A  certain  man  improves  the  opportunity  offered  by  a  growing 
city  of  40,000  inhabitants  to  develop  a  messenger  service  business,  from 
which  at  the  end  of  three  years  he  finds  himself  getting  a  net  return, 
after  allowing  himself  wages  for  management,  of  $700.  The  capital  in- 
vested, which  includes  a  bank  balance  of  $200  which  he  commonly  main- 
tains, is  only  $500;  but  he  has  to  provide  for  a  pay-roll  of  about  $200  a 
month  or  $2,400  a  year.  He  now  tries  to  sell  out  the  business,  asking  for 
it  $8,750.  Assuming  that  the  good  will  of  the  business  is  worth  $500,  and 
that  8  per  cent  is  a  reasonable  rate  of  interest  and  profit,  is  the  price 
proposed  a  reasonable  one?  Does  the  size  of  the  pay-roll  make  any 
difference  ?  Explain. 


CHAPTER  XXVIII 


Final  Price  Determination. — In  introducing  the  study  of  mar- 
ket price,  we  explained  that  our  complete  treatment  of  the  principles 
and  processes  of  price  determination  would  fall  into  three  parts. 
The  first  two  parts,  one  dealing  with  the  more  immediate  processes 
of  market  price  determination,  and  the  second  concerned  with  a  set 
of  the  deeper  forces  involved  in  the  determination  of  normal  price, 
have  been  completed.  These  two  studies  have  treated  of  the  nature 
and  operation  of  those  processes  with  which  the  business  man  in 
general  is  most  immediately  concerned,  and  a  knowledge  of  which  is 
usually  sufficient  for  his  immediate  purposes.  There  is  a  third  set 
of  forces,  however,  lying  deeper  than  any  yet  treated,  which  it  is 
now  our  task  to  study.  We  must  now  try  to  get  beneath  the  surface 
processes  already  considered,  to  processes  and  forces  which  are,  in  a 
logical  sense,  ultimate;  to  go  beyond  conclusions  which  are  often 
merely  provisional,  to  those  which  are  in  some  sense  definitive;  to 
leave  points  of  view  which  are  partial,  for  one  which  includes  the 
field  as  a  whole.  In  a  word,  our  task  now  is  to  attempt  a  considera- 
tion of  those  fundamental  forces  and  processes  which  govern  the 
field  of  price  as  a  totality. 

Inadequacy  of  Our  Previous  Treatment. — The  essential  de- 
ficiency in  our  previous  treatment  of  the  price  problem  is  to  be 
found  in  the  fact  that,  in  all  those  cases  in  which  cost  of  production 
has  been  represented  as  playing  a  part  in  price  determination,  we 
have  assumed  that  nothing  need  be  said  about  the  determination  of 
that  cost  itself.  In  other  words,  we  have  assumed  that  costs  are 
data  given  in  advance,  determinate  from  the  beginning.  As  we  have 
pictured  the  matter,  the  entrepreneur,  starting  out  to  produce  some 

J57 


358  PRINCIPLES  OF  ECONOMICS 

commodity,  finds  that  he  must  pay  so  much  for  raw  materials,  so 
much  for  tools  and  machinery,  so  much  for  labor,  so  much  for  the 
use  of  capital,  and  so  on.  In  consequence  of  these  outlays,  and  in 
consideration  of  his  own  sacrifices,  he  fixes  upon  a  price  which  con- 
ditions the  forthcoming  of  his  supply,  the  supply  price  of  a  given 
quantity  of  the  commodity  in  question.  Since  it  is  a  supply  price,  it 
is  bound  to  influence  actual  price,  is  bound,  at  any  rate,  to  furnish  a 
point  below  which  actual  price  cannot  go  if  this  increment  of  the 
supply  is  to  be  had. 

But,  now,  what  are  the  outlays  which  the  entrepreneur  has  to 
make?  Plainly,  they  are  nothing  more  than  the  sum  of  money 
values  of  the  factors  he  puts  into  the  product,  such  value  in  each 
case  being  equal  to  the  price  of  the  factor  involved,  multiplied  by 
the  number  of  units  employed.  That  is,  costs,  in  so  far  as  they  con- 
sist of  outlays,  are  themselves  nothing  but  aggregates  of  prices,  the 
prices  of  the  factors  or  cost-goods  used  up  in  the  process  of  pro- 
duction. This  applies  not  only  to  the  factors  and  cost-goods  which 
the  entrepreneur  buys  on  the  market,  but  also,  in  large  measure,1 
to  those  which  he  himself  contributes.  If  he  supplies  labor  services, 
he  cannot  hope  to  get  in  return  higher  wages  than  the  market  rate 
for  similar  types  of  labor;  nor  can  he  get  a  higher  rate  of  interest 
for  the  capital  he  himself  puts  into  the  business  than  the  rate  pre- 
vailing on  the  market. 

It  follows  from  what  has  just  been  said  that  in  treating  costs  as 
data  given  in  advance,  as  independent  of  the  problem  of  price  de- 
termination, we  have  ignored  quite  evident  facts.  Costs  are  not 
fixed  in  advance.  They  are  not  fixed  outside  of  the  price-determinat- 
ing process.  Being  themselves  dependent  on  the  prices  of  cost- 
goods,  the  explanation  of  the  process  whereby  they  are  determined 
forms  an  integral  part  of  the  total  problem  of  price  determination. 
In  so  far  then  as  we  have  built  on  costs,  as  if  these  constituted  a 
foundation  below  which  it  was  unnecessary  to  go,  we  have  left  our 
task  incomplete.  Such  a  procedure  was  doubtless  legitimate  from 
the  standpoint  of  what  we  called  normal  price,  since  it  was  reason- 


case. 


profit  on  capital  received  by  the  entrepreneur  furnishes  a  special 


XXVIII]  PRIMARY  FACTORS  AND  DISUTILITY 


359 


able  to  assume  that,  from  the  standpoint  of  the  individual  entre- 
preneur, for  periods  sufficiently  short  to  be  of  interest  to  him,  the 
prices  of  cost  goods  have  in  normal  times  a  degree  of  fixity  sufficient 
to  warrant  his  acting  as  if  they  did  not  change.  Nevertheless,  from 
the  point  of  view  of  the  entire  problem  of  price  determination,  there 
is  a  gap  in  our  explanation.  We  have  not  explained  the  process  by 
which  the  prices  of  cost-goods  are  determined,  although  it  is  now 
evident  that  these  prices  play  a  very  important  role  in  the  process  of 
price  determination. 

Produced  Factors  Partly  Covered. — This  account  of  the  in- 
sufficiency of  our  previous  treatment  of  price  determination,  how- 
ever, needs  some  qualification,  and  comment  upon  this  qualification 
will  aid  in  further  defining  our  present  problem.  A  large  number 
of  the  factors  used  by  the  entrepreneur  in  production  are  them- 
selves products.  This  being  true,  an  account  of  the  principles  under 
which  the  prices  of  products  in  general  are  determined,  must  also 
explain,  in  part  at  least,  the  processes  whereby  the  prices  of  those 
factors  of  production,  which  are  themselves  produced,  are  deter- 
mined. In  fact,  the  great  majority  of  cases  to  which  our  previous 
account  of  normal  price  is  applicable,  are  not  final  products,  that  is, 
such  as  are  destined  for  the  direct  satisfying  of  wants,  but  they  are 
factors  used  in  making  these  final  products.  It  follows,  therefore, 
that  in  treating  immediate  price  determination  and  normal  price,  we 
have  covered  to  some  extent  this  type  of  factor  or  cost-goods  as 
well  as  final  products. 

At  this  point,  however,  we  must  again  guard  against  over- 
statement. If,  in  our  theory  of  the  prices  of  products,  those  prices 
had  been  made  dependent  on  cost  of  production  solely,  there  would 
naturally  have  been  no  difference  in  the  case  of  goods  intended  for 
final  consumption  and  goods  employed  in  further  production.  In 
fact,  however,  prices  of  goods  for  final  consumption  were  repre- 
sented as  influenced  not  only  by  cost  but  also  by  their  importance  or 
significance  to  consumers.  But  this  significance  to  consumers  as  a 
determining  element  in  price,  cannot  be  directly  applied  to  goods 
which  are  used  only  in  production.  A  footnote  on  page  303  called 
attention  to  this  gap  in  our  explanation.  While  affirming  at  that 


360  PRINCIPLES  OF  ECONOMICS  [XXVIII 

point  the  almost  certain  influence  of  the  significance  of  final  or  con- 
sumers' products  on  the  prices  of  producers'  goods  used  in  their 
production,  we  then  reserved  further  comment  on  this  matter;  and 
now,  while  studying  the  problem  of  final  price  determination,  we  are 
still  facing  the  task  of  explaining  the  connection  between  the  sig- 
nificance of  the  final  products  to  the  consumer  and  the  prices  of 
intermediate  products  entering  into  them. 

Primary  Factors. — We  have  seen  that  our  study  of  price 
determination  needs  to  be  supplemented  in  order  to  provide  a  fuller 
explanation  of  the  prices  of  those  products  which  serve  as  factors  in 
further  production.  The  case  of  factors  which  are  not  produced, 
factors  behind  which  it  is  not  possible  to  go  in  the  analysis  of  the 
productive  process,  primary  factors, — these,  still  more  notably, 
present  to  us  a  supplementary  problem,  a  problem  which  has  to  be 
taken  up  in  any  explanation  of-the  final  processes  of  price  determina- 
tion. In  attempting  the  solution  of  this  general  problem  of  the 
prices  of  factors  or  cost-goods,  we  shall  confine  our  attention  to  the 
second  case,  that  is,  the  case  of  primary  factors,  on  the  ground 
that,  in  so  far  as  the  case  of  produced  factors  has  not  already  been 
provided  for  under  normal  price,  the  conclusions  reached  with 
respect  to  primary  factors  will  be  applicable  without  material  change 
to  produced  factors.  Accordingly  we  will  now  enter  upon  the  task 
of  answering  the  question :  How  are  the  prices  of  primary  factors 
determined? 

Different  Solutions  of  Problem. — In  economic  texts,  the  prob- 
lem we  have  thus  set  ourselves  has  seldom  been  clearly  isolated, 
being  usually  confused  with  that  presented  by  the  more  superficial 
processes  of  price-determination  which  have  been  studied  in  previous 
chapters.  Nevertheless,  one  may  distinguish  at  least  three  types  of 
doctrine  concerning  this  problem,  as  being  implicit  in  price  discus- 
sion. One  group  of  writers  teach  that  the  value  or  price  of  the  pri- 
mary factors  is  determined  solely  by  their  marginal  utility:  the  pro- 
ductive capacities  and  resources  of  man  are  progressively  distributed 
over  the  whole  field  of  production,  from  the  most  important  products 
downward  till  they  are  all  used,  and  their  utility  in  the  marginal  use 


XXVIII]  PRIMARY  FACTORS  AND  DISUTILITY  361 

fixes  their  value.  A  second  group  find  the  sole  determinant  in  the 
cost, — the  disutility  cost — of  supplying  directly  the  human  elements 
and  making  available  the  elements  coming  from  nature,  outside  of 
man.  Psychic  cost  is  the  original  cost  of  everything,  and  determines 
what  we  must  pay  to  secure  the  forthcoming  of  supply.  A  third 
group  recognize  the  presence  of  both  utility  and  cost  determinants 
in  the  process,  advocating  what  is  often  called  an  equilibrium  theory. 

The  Doctrine  of  This  Text. — The  doctrine  maintained  in  this 
text  is  a  form  of  the  equilibrium  theory.  It  gives  most  weight  to 
significance  or  utility,  but  it  insists  on  recognizing  the  influence  of 
disutility  cost  in  the  case  of  those  primary  factors  which  can  be 
supplied  only  by  processes  which  involve  that  element.  It  may  be 
formulated  for  the  sake  of  definiteness  in  the  following  statement : 

Principle — Significance-Disutility  Principle. 

The  price  of  any  primary  factors  tends  to  be  that 
price  which  expresses  the  effective  significance  or  value 
of  that  factor  over  the  whole  field  of  production,  and 
which  also  expresses  a  disutility,  not  less  than  the  marginal 
one  and  not  as  great  as  the  first  extra-marginal  one,  in- 
volved in  supplying  the  quantity  of  said  factor  which  is 
actually  supplied,  in  case  such  a  disutility  exists. 

In  maintaining  this  proposition,  we  will  begin  with  the  second 
or  disutility  part  as  involving  fewer  difficulties  in  analysis  and 
presentation.  This  topic  will  occupy  the  remainder  of  the  present 
chapter. 

Primary  Factors  and  Disutility. — It  is  a  fact  too  evident  to 
need  argument  that  the  supplying  of  those  primary  factors  which  are 
of  human  origin  may,  at  any  rate,  involve  a  disutility  or  "pain-cost." 
Working  or  saving  or  taking  responsibility  can  be  carried  so  far  as 
to  be  distasteful.  Further,  it  cannot  be  doubted  that  at  the  present 
time,  in  societies  which  have  attained  to  any  high  economic  develop- 
ment, the  supplying  of  these  services  has,  with  many  of  the  persons 
concerned,  gone  so  far  that  disutility  is  actually  felt.  Much  or 


362  PRINCIPLES  OF  ECONOMICS  fXXVIII 

most  of  the  labor  furnished  carries  with  it  a  psychic  sacrifice,  and 
the  same  is  true  of  some  part  of  the  saving  and  responsibility-taking. 
Still  again,  it  is  a  familiar  fact  that  the  disutility  or  pain-cost  of 
supplying  these  human  primary  factors  increases  with  the  amount 
supplied  and  diminishes  as  that  amount  diminishes.  That  is,  dis- 
utility varies  directly  with  the  quantity  supplied. 

Human  Factors  Have  Supply  Prices. — Again,  it  cannot  be 
doubted  that  the  amount  of  supply  is  influenced  by  the  disutility 
involved.  Some  persons,  anyhow,  supply  less  than  they  would  if 
the  disutility  of  doing  this  were  diminished.  Most  of  us  do  not  work 
as  many  hours  per  week,  or  month,  or  year,  as  we  would  if  there 
were  no  disutility  attaching  to  our  efforts ;  and  the  same  surely  is 
applicable  to  saving  and  responsibility-taking.  It  follows  that  any 
primary  factor  of  human  origin  may  be  expected  to  have  a  supply 
price  for  each  different  quantity  of  such  factor  supplied,  that  is,  a 
price  on  which  is  conditioned  the  forthcoming  of  that  particular 
quantity,  and,  therefore,  may  be  expected  to  have  a  supply  schedule 
closely  analogous  to  the  perfectly  elastic  supply  schedule  which 
appears  on  page  270.  If,  at  any  time,  an  increase  in  the  amount  is 
demanded,  a  higher  price  will  be  necessary  to  bring  out  that  increase, 
and,  conversely,  a  higher  price  will  bring  out  that  increase.2 

Supply  Prices  Influence  Actual  Price. — But,  admitted  that 
primary  factors  the  supplying  of  which  involves  a  disutility  have  a 
supply  schedule  of  the  typical  sort,  it  necessarily  follows  that  such 
a  factor  would  tend  to  have  its  price  fixed  by  the  same  limiting 
prices  from  the  supply  side  which  are  effective  in  the  case  of  com- 
modities generally.  That  is,  the  actual  price  of  such  a  primary  factor 
could  not  go  below  the  marginal  supply  price  nor  up  to  the  first  extra- 
marginal  supply  price.  Buyers  could  not  let  price  fall  below  the 
marginal  supply  price ;  since,  in-  that  case,  they  would  lose  the  mar- 


1  Interesting  exceptions  to  this  principle  have  been  noted,  particularly  this 
one :  that  the  higher  price  of  labor  at  times  brings  out,  not  a  larger,  but  a 
smaller,  supply.  The  men  furnishing  this  factor  prefer  to  increase  their 
leisure  rather  than  their  income.  But  it  would  seem  that  this  sort  of  thing 
must  be  looked  upon  as  an  irregularity  only,  not  as  materially  affecting  the 
Whole  course  of  things. 


XXVIII]  PRIMARY  FACTORS  AND  DISUTILITY  363 

ginal  increment  of  supply.  On  the  other  hand,  included  sellers  could 
not  let  actual  price  go  up  to  the  first  extra-marginal  supply  price; 
since,  in  that  case,  they  would  let  in  an  excess  of  supply  and  so 
would  run  the  risk  of  failing  to  dispose  of  some  portion  of  their 
offering. 

Disutility  Principle  Established. — The  foregoing  would  seem 
to  establish  beyond  question  the  second  part  of  our  principle  with 
respect  to  the  prices  of  primary  factors,  the  part,  namely,  which 
affirms  that  the  price  of  any  primary  factor  tends  to  be  a  price  which 
expresses  a  disutility  not  less  than  the  marginal  one  and  not  as 
great  as  the  first  extra-marginal  one  involved  in  supplying  the 
quantity  of  said  factor  which  is  actually  supplied,  in  case  such  a 
disutility  exists. 


CHAPTER  XXIX 

THE  PRICES  OF  PRIMARY  FACTORS  AND 
SIGNIFICANCE 

Whether  or  not  the  significance  of  factors  in  production  has  any 
considerable  part  in  fixing  their  value  or  price  is  still  a  matter  of 
controversy  among  economists.  The  wide-spread  acceptance  of  the 
so-called  marginal  productivity  doctrine,  which  characterized  eco- 
nomic writing  perhaps  twenty  years  ago,  has  been  followed  by  some 
reaction.  Indeed,  not  a  few  of  the  younger  economists  speak  with 
some  contempt  of  this  whole  point  of  view.  Nevertheless,  it  is 
doubtful  if  anyone  would  have  the  hardihood  to  deny  the  existence 
of  some  connection  between  the  significance  of  factors  and  their 
prices.  For  practically  everyone  assents  without  hesitation  to  the 
general  proposition  that,  as  far  as  buyers  are  concerned,  there  is 
no  reason  why  factors  should  have  any  price  at  all  except  the  fact 
that  the  products  which  result  from  the  use  of  those  factors  have 
significance  or  value.  Probably,  in  this  case  as  in  so  many  others, 
the  real  difference  between  the  advocates  and  opponents  of  the 
doctrine  here  maintained  has  respect  to  the  degree  to  which  the  pre- 
sumable connection  between  the  prices  of  factors  and  their  impor- 
tance in  products  is  realized.  At  one  extreme  will  be  found  those 
who  seem  to  speak  as  if  there  were  almost  exact  correspondence 
between  the  significance  of  any  factor  in  production  and  the  price 
which  it  commands  on  the  open  market ;  while  at  the  other  extreme 
appear  a  group  of  thinkers  who  seem  to  consider  the  correspondence 
between  importance  and  price  so  slight  as  to  be  almost  negligible. 
In  the  opinion  of  the  present  writer,  neither  extreme  is  defensible. 
Significance  influences  very  greatly  the  prices  of  primary  factors ; 
but  precise  correspondence  between  the  two  is  surely  not  realized. 

Our  defense  of  the  contention  that  significance  plays  a  large  part 
in  determining  the  prices  of  primary  factors  will  follow  two  lines : 

364 


XXIX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  365 

First,  we  shall  try  to  show  that  there  are  conditions  under  which 
there  is  some  clue  to  the  significance  of  a  specific  factor  in  the 
particular  productive  processes  in  which  it  is  employed,  in  which 
case  the  reciprocal  competition  of  producers  tends  to  give  such 
factor  a  price  expressing  its  effective  significance  over  the  whole 
field.  Secondly,  we  shall  try  to  show  that,  even  under  conditions 
where  no  such  clue  is  to  be  had,  where  there  is  no  way  of  ascertain- 
ing the  significance  of  any  factor  in  the  particular  productive  pro- 
cesses in  which  it  is  employed,  nevertheless  the  spontaneous  work- 
ing of  the  price-making  forces  tends  to  give  each  factor  a  price  ex- 
pressing the  effective  significance  of  that  factor.  In  this  chapter, 
we  shall  confine  ourselves  to  the  former  of  these  two  lines  of 
argument. 

I 

Knowledge  of  Significance  in  Particular  Operations  when  a 
Factor  is  Acting  Alone 

In  the  first  place,  there  is  an  appreciable  number  of  cases  in 
which  only  one  of  the  factors  involved  is  an  economic  factor.  For 
example,  let  us  suppose  that  the  productive  process  involved  is  piling 
into  proper  shape  a  cord  of  wood  just  delivered, — a  process  requir- 
ing only  a  very  simple  form  of  labor.  In  such  a  case,  manifestly, 
the  buyer  of  the  single  factor  required  could,  without  difficulty, 
ascertain  quite  precisely  the  product  of  that  factor — the  physical 
result  which  it  accomplished  in  the  particular  productive  process ; 
since  that  product  is  simply  the  changed  condition  of  the  wood — the 
condition  of  being  piled.  Again,  it  is  plain  that  the  buyer  of  the 
factor  could  easily  ascertain  the  significance  of  that  factor  in  this 
particular  productive  process ;  for,  obviously,  that  significance  is 
just  the  same  as  the  significance  of  the  product  itself — the  changed 
condition  of  the  wood. 

Many  examples  analogous  to  this  are  supplied  by  laborers  en- 
gaged in  furnishing  various  sorts  of  personal  services,  including 
services  to  the  household.  These  laborers  may  properly  be  regarded 
as  acting  alone,  furnishing  one  factor  which  is  operating,  not  jointly 
with  other  factors,  but  by  itself.  It  is  true  that  in  such  cases  other 
factors  are  usually  involved,  but  they  may  be  disregarded  because 


366  PRINCIPLES  OF  ECONOMICS  [XXIX 

the  quantity  of  these  other  factors  used  is  so  small,  in  comparison 
with  the  quantity  of  labor  employed,  that  their  influence  is  negligible. 

Free  Land  Available. — A  much  more  important  example  of  a 
single  factor  acting  alone  is  found  in  new  countries  where  there  is 
an  abundance  of  free  land  available  to  which  labor  can  betake  itself 
and  make  a  living.  Under  these  conditions,  there  is  substantially  but 
one  factor,  that  is,  labor,  the  other  principal  factor,  land,  being 
non-economic.  It  is  true  that,  in  cases  like  this,  some  little  capital 
is  needed,  but  the  amount  is  so  small  that  it  may  be  regarded  as 
negligible.  Whatever  the  laborer  produces,  then,  is  recognized  as 
his  product  in  a  specific  and  special  sense. 

Numerous  Cases  Not  Needed. — It  may  be  objected  to  giving 
the  cases  just  commented  upon  much  weight  in  our  present  problem 
that,  at  the  most,  cases  of  the  sort  form  but  a  small  per  cent  of  the 
total,  so  small,  indeed,  that  one  cannot  help  wondering  if  they  have 
any  influence  in  the  matter.  To  this  objection,  the  easy  answer  is 
that,  in  nearly  all  cases  of  price  determination,  it  is  small  quantities 
of  supply  which  are  decisive,  namely,  the  marginal  and  first  extra- 
marginal  increments.  These,  to  be  sure,  must  be  sufficiently  large 
to  affect  appreciably  the  total  supply,  else  sellers  would  not  trouble 
themselves  to  bid  price  down  in  order  to  include  the  marginal  in- 
crement of  demand,  and  buyers  would  not  trouble  themselves  to 
bid  price  up  in  order  to  exclude  the  first  extra-marginal  increment 
of  demand.  But  a  very  small  per  cent  of  the  total  is  sufficient  for  this. 

Accordingly,  a  correct  decision  in  respect  to  the  question  whether 
or  not  the  cases  of  factors  which  act  alone  have  any  material  in- 
fluence on  the  prices  of  those  factors,  turns  on  whether  or  not  the 
cases  where  the  specific  economic  product  of  a  factor  can  be  isolated 
occupy  the  crucial  positions  indicated :  Do  they  lie  at  the  margin  ? 
There  is  certainly  a  possibility  that  they  do  occupy  this  position. 
Historians  have  nearly  always  agreed  that,  in  the  case  of  colonial 
America,  the  possibility,  open  to  laborers,  of  going  over  the  moun- 
tains into  the  unappropriated  land  constituted  a  first  extra-marginal 
demand  for  labor  which  compelled  the  employer  in  the  settled  dis- 
tricts to  bid  wages  up  to  a  higher  figure  than  they  would  otherwise 


XXIX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  367 

have  reached.  Even  in  a  highly  developed  and  static  society,  it 
seems  not  unlikely  that  the  types  of  casual  labor,  which  largely  act 
in  isolation,  play  a  considerable  part  in  that  they  are  exceptionally 
mobile,  exceptionally  determined  to  have  the  best  price  the  market 
will  justify.  At  any  rate,  this  much  is  certain,  that  in  so  far  as  the 
type  of  labor  which  is  substantially  acting  alone  does  in  reality  oc- 
cupy the  crucial  place  at  the  margin,  the  price  of  that  factor  must 
tend  to  settle  at  a  point  not  above  the  marginal  significance  of  such 
labor,  nor  as  low  as  the  first  extra-marginal. 

II 

Knowledge  of  Significance  in  Particular  Operations  when  Several 
Factors  are  Cooperating 

Allocation  or  Imputation  of  Economic  Product. — We  have  com- 
mented on  those  cases  where  the  particular  significance  of  a  factor 
can  be  ascertained  because  that  factor,  economically  speaking,  is 
acting  independently, — all  other  factors  are  either  non-economic  or 
negligible  in  amount.  But  no  one  would  contend  that  cases  of  this 
sort  are  predominant.  Almost  always  many  different  factors  are 
acting  jointly.  It  follows,  therefore,  that,  if  we  are  to  get  much 
help  from  cases  wherein  the  significance  of  the  factor  in  particular 
processes  can  be  ascertained,  we  must  find  some  method  of  isolating 
the  significance  of  an  economic  factor  even  when  it  is  operating 
jointly  with  other  economic  factors.  But  this,  in  turn,  requires  that 
we  should  discover  some  process  whereby  we  can  isolate  a  specific 
portion  of  the  product  of  the  particular  operation  in  which  our  factor 
appears,  as  being  a  portion  which  can  legitimately  be  imputed  or 
credited  to  that  factor.  The  process  by  which  such  isolating  of 
portions  of  the  common  product  may  be  accomplished,  if  accom- 
plished at  all,  is  frequently  designated  "imputation."  To  distinguish 
it  from  other  analogous  processes  to  which  we  may  find  it  convenient 
to  apply  the  term,  we  shall  call  the  case  before  us  "product  imputa- 
tion" or  "imputation  of  economic  product." 

Meaning  of  Economic  Product. — Before  commenting  on  the 
possible  solution  of  the  problem  of  product  imputation,  we  must 


368  PRINCIPLES  OF  ECONOMICS  [XXIX 

realize  quite  fully  in  just  what  sense  the  word  "product"  is  used  in 
this  connection.  First,  we  surely  must  not  think  of  ourselves  as  try- 
ing to  discover  some  method  of  ascertaining  the  literal  product  of 
each  factor  in  a  joint  process.  The  very  notion  of  accomplishing 
such  a  result  is  absurd.  Literally  speaking,  the  whole  product  is 
produced  by  all  the  factors  acting  together.  All  we  can  hope 
to  do,  all  we  need  to  do,  is  to  isolate  the  economic  product  of  the 
factor  in  question.  By  economic  product  we  mean  the  portion  of 
the  product  which  we  can  properly  treat  as  if  it  were  the  product  of 
the  one  factor  under  consideration.  In  other  words,  if  in  our  eco- 
nomic conduct  we  behave  as  if  a  certain  portion  of  the  product  were 
literally  produced  by  the  given  factor  alone,  and  find  that,  in  doing 
this,  we  have  done  just  the  right  thing,  economically  speaking,  then 
that  portion  of  the  product  which  we  treated  as  if  it  were  the 
product  of  the  factor  in  question  alone,  actually  is  the  economic 
product  of  that  factor. 

This  case  is  most  easily  illustrated  from  the  product  rent  of  a 
piece  of  land  used  for  farming.  Let  us  start  with  the  idea  that  land 
is  of  many  grades  in  respect  to  efficiency ;  and  that  there  is  such  an 
abundance  of  the  land  of  the  lowest  grade  which  it  pays  to  cultivate 
that  much  of  it  is  unused  when  we  have  put  under  cultivation  all 
that  we  need.  In  such  a  case,  the  lowest  grade  of  land  under  culti- 
vation, called  marginal  land,  will  not  be  accounted  an  economic 
factor  at  all,  will  be  a  free  good.  If,  now,  an  acre  of  better  land 
yields  to  a  certain  amount  of  expenditure  six  bushels  of  wheat  more 
than  this  marginal  or  non-economic  land  yields  to  the  same  expendi- 
ture, that  six  bushels  of  wheat  will  be  properly  credited  to  said 
acre  of  land  as  being,  economically  speaking,  the  specific  product  of 
that  land  alone.  This,  of  course,  does  not  mean  that  those  six  bushels 
are  produced  by  the  land  without  the  aid  of  the  other  factors ;  but 
merely  that  we  can  behave  as  if  this  were  the  case  and  in  doing  so 
will  act  wisely.  In  other  words,  a  farmer  .wishing  to  cultivate  this 
piece  of  land  would  act  wisely  were  he  to  pay  for  the  privilege  of 
doing  so  a  share  of  the  product  not  in  excess  of  six  bushels. 

Surplus  Method  of  Imputation. — Having  now  before  us  the 
concept  of  economic  product,  the  question  presents  itself :  How  far 


XXIX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  369 

can  this  product  be  isolated,  how  far  can  the  problem  of  imputation 
be  solved  ?  One  method  of  doing  this  is  suggested  by  the  illustration 
just  used  in  explaining  what  we  mean  by  economic  product.  That 
method  we  may  call  the  surplus  method,  since  it  depends  on  showing 
that  the  factor  which  is  under  consideration  yields  a  surplus  over 
another  specimen  of  the  same  kind  of  factor  which  is  a  non-eco- 
nomic factor.  This  particular  method  of  imputation  is  habitually 
applied  to  land ;  and  has  long  been  looked  on  as  fairly  adequate  to 
isolate  the  specific  product  of  this  factor  in  the  particular  operations 
where  it  is  being  employed.  Since  it  isolates  the  product  economi- 
cally imputable  to  the  services  of  the  land,  it  also,  of  necessity, 
isolates  the  importance  or  significance  of  those  services ;  and  this, 
in  turn,  insures  that  those  services  shall  have  a  price  expressing  a 
significance  not  as  low  as  their  first  extra-marginal  one,  nor  higher 
than  their  marginal  one.  It  follows  that  land,  or  land  services,  when 
used  in  farming  anyhow,  may  be  looked  on  as  a  primary  factor  which 
in  a  very  high  degree  realizes  the  principle  we  are  defending^ 
that  is,  the  principle  that  a  factor  tends  to  have  a  price  expressing 
its  effective  significance  over  the  whole  economic  field.  And  it  is 
probably  fair  to  say  that  this  view  has  been  held  explicitly  or  im- 
plicitly by  the  great  majority  of  economists. 

Dosing  Method  of  Imputation. — A  second  method  of  product 
imputation  which  has  wide  acceptance  may  be  called  the  "dosing" 
method.  This  method  thinks  of  the  entrepreneur  as  making  a  series 
of  experiments  in  which  all  but  one  of  the  factors  engaged  in  a  joint 
productive  process  are  kept  constant,  while  successive  units  of  that 
one  are  added.  The  addition  to  product  which  follows  the  addition 
of  the  last  or  marginal  unit  of  this  particular  factor  is  accounted 
the  economic  product  of  that  unit.  Further,  since  the  different 
units  of  said  factor  are  reciprocally  interchangeable,  the  addition  to 
product  which  follows  the  addition  of  the  marginal  unit  of  the 
factor  is  accounted  the  effective  economic  product  of  any  unit  of 
said  factor.  If  this  method  is  theoretically  sound  and  feasible  in 
practice,  such  experimentation  would  give  each  producer  informa- 
tion as  to  the  effective  economic  product  and  hence  as  to  the  effective 
significance  of  the  factor  in  question  in  his  particular  business. 


370  PRINCIPLES  OF  ECONOMICS  [XXIX 

Whereupon,  the  competition  of  producers  in  different  fields  would 
insure  that  the  price  of  that  factor  could  not  be  as  low  as  its  first 
extra-marginal  significance,  nor  above  its  marginal  significance  over 
the  field  of  production  as  a  whole. 

In  the  opinion  of  the  writer,  this  method  of  imputation  is  of 
much  less  general  applicability  than  its  advocates  seem  to  believe. 
A  good  case  can  be  made  for  its  feasibility  only  in  the  simpler  types 
of  industry,  particularly,  farming.  Nevertheless,  since  such  indus- 
tries utilize  a  very  considerable  portion  of  our  store  of  primary 
factors,  a  method  which  can  claim  a  considerable  degree  of  success 
in  isolating  the  economic  product  of  factors  in  that  particular  field, 
surely  ought  not  to  be  ignored  in  connection  with  the  question  we 
are  now  considering. 

Economic  Product  and  Significance. — It  is  hardly  necessary 
to  say  that,  if  by  any  of  the  methods  commented  upon  above  we 
are  able  to  isolate  the  economic  product  of  a  given  factor  in  a 
particular  productive  operation,  we  shall  also  be  able  to  isolate  the 
significance  of  said  factor  in  that  particular  operation.  For  the 
significance  of  said  factor  would  of  course  be  the  same  as  the 
significance  of  its  product;  and  that,  we  may  assume,  would  be 
clearly  expressed  in  the  money  value  of  that  product. 

Ill 

Knowledge  of  Significance  in  the  Particular  Industry  Insures  a 
Price  Expressing  Significance  over  the  Whole  Field 

We  have  tried  to  show  that  in  not  a  few  cases  the  entrepreneur 
is  able  to  ascertain  in  one  way  or  another  something  about  the 
significance  or  importance  of  a  given  factor  in  the  particular  indus- 
trial process  in  which  it  is  operating.  We  have  now  to  show  that 
when  this  is  true  the  natural  working  of  competition  must  tend  to 
establish  for  said  factor  a  price  which  expresses  its  effective  sig- 
nificance over  the  whole  field.  The  reasoning  by  which  this  propo- 
sition is  supported  is  plain.  If  the  producer  is  able  to  ascertain  the 
true  significance  of  the  factors  in  his  particular  operation,  he  will,  of 
course,  be  ready  to  bid  for  a  unit  of  such  factor  a  price  as  high  as 


XXIX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  37! 

one  which  expresses  such  significance.  But,  with  such  a  condition 
realized,  the  reciprocal  bidding  of  different  entrepreneurs  must  cer- 
tainly keep  the  price  from  going  as  low  as  one  which  expresses  the 
first  extra-marginal  significance,  since  this  is  necessary  in  order  that 
extra-marginal  buyers  should  be  excluded.  On  the  other  hand,  the 
persons  who  supply  said  factor  must  bid  the  price  down  to  a  price 
not  higher  than  the  one  which  expresses  the  marginal  significance 
of  said  factor,  since  otherwise  the  marginal  buyers  would  be  ex- 
cluded. Accordingly,  under  the  condition  supposed,  that  is,  the 
condition  which  makes  significance  in  the  particular  case  ascertain- 
able,  the  ordinary  working  of  economic  forces  will  tend  to  set  the 
actual  price  of  each  factor  at  a  point  not  as  low  as  the  first  extra-' 
marginal  significance  of  that  factor  over  the  whole  field,  but,  at  the 
same  time,  not  higher  than  its  marginal  significance  over  the  whole 
field. 


CHAPTER  XXX 

THE   PRICES   OF   PRIMARY   FACTORS   AND 
SIGNIFICANCE  (CONTINUED) 

The  method  employed  in  the  preceding  chapter,  in  maintaining 
the  doctrine  that  the  effective  significance  of  a  primary  factor  over 
the  whole  economic  field  has  a  part  in  determining  its  price,  was  built 
on  the  assumption  that  it  is  possible,  to  some  extent  at  any  rate,  to 
isolate  the  significance  of  such  factor  in  particular  productive  opera- 
tions. The  result  of  that  argument  seems  to  justify  the  claim  that 
we  have  a  strong  presumption  for  the  fairly  complete  dominance  of 
our  principle  in  some  cases,  notably  that  of  land,  and  for  a  decided 
tendency  toward  such  dominance  in  not  a  few  other  cases.  I  am 
not  content,  however,  to  leave  the  matter  at  this  point.  It  seems  to 
me  that  we  have  it  in  our  power  to  go  much  further, — that  we  are 
able  to  show  the  presence  of  price-determining  processes,  which, 
though  indirect  in  their  action,  are  more  important  than  all  the 
direct  ones  enumerated,  which  processes,  under  the  theoretically 
perfect  conditions  of  abstract  economics,  would  make  the  prices  of 
all  primary  factors  precisely  the  ones  which  express  the  effective 
significance  of  those  factors,  and  that  without  the  assistance  of  any 
of  the  processes  which  have  been  discussed  hitherto.  Further,  I  be- 
lieve that,  even  under  actual  conditions,  this  proposition  has  suf- 
ficient applicability  to  make  it  of  great  importance.  This  being  so, 
it  now  becomes  our  duty  to  give  this  matter  a  full  presentation. 

Conditions  Assumed. — In  order  to  make  clear  that  the 
processes  upon  which  this  theory  depends  have  no  connection  with 
those  which  were  presented  in  the  preceding  chapter,  and  also  to 
make  the  precise  nature  of  these  processes  stand  out  in  the  most 
definite  manner  possible,  I  propose  to  start  with  a  hypothesis  where- 
in we  could  have  no  clue  whatever  to  the  significance  of  a  factor  in 

372 


XXX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  373 

the  particular  operation  in  which  it  was  being  employed.  That  is, 
we  shall  start  with  a  hypothesis  under  which,  by  assumption,  there 
is  no  possibility  of  finding  a  case  in  which  the  factor  we  were  study- 
ing was  working  unassisted  by  other  economic  factors ;  and  there 
would  be  no  possibility  of  ascertaining  the  specific  product  of  that 
factor  by  either  the  "surplus"  method,  or  the  "dosing"  method  of 
imputation.1  I  shall  try  to  show  that  even  under  these  rigorous  con- 
ditions every  primary  factor  would  inevitably  come  to  have  a  price 
which  expressed  the  effective  significance  of  that  factor, — provided 
always  that  the  fundamental  conditions  assumed  in  all  price  theory 
are  fully  realized. 

I 

Each  Factor  in  Joint  Processes  Has  Its  Specific  Significance  in 

Such  Processes  Even  if  That  Specific  Significance 

Cannot  Be  Ascertained 

Our  first  task  in  maintaining  this  thesis  is  to  convince  ourselves 
that  there  really  exists  such  a  specific  significance  attaching  to  each 
factor — for  this  proposition  is  not  manifest  on  the  surface.  In  fact, 
a  case  could  be  made  for  the  contention  that  the  very  idea  of  such  a 
specific  significance  for  each  factor  under  the  conditions  which  we 
have  assumed,  is  absurd.  Thus,  let  us  suppose  that  one  unit  of  a 
certain  commodity,  which  we  will  designate  as  P»,  requires  for  its 
production  the  cooperation  of  three  factors  which  we  will  designate 
Fi,  F:,  F3,  respectively;  that  these  factors  are  combined  in  the  pro- 
portion of  4Fi's,  3F2's,  and  nF3's;  and  that  there  is  no  possibility  of 
isolating  some  fractional  part  of  the  product  as  being  produced  by  the 
4Fi's,  another  part  as  being  produced  by  the  3F/s,  and  another  part 
as  being  produced  by  the  nFs's.  If,  now,  we  assume  that  a  unit  of 
the  product,  Pi,  has  a  significance  of  86  cents,  then,  obviously,  the 
4Fi's,  the  3F2's,  and  the  uFa's  must  together  have  a  joint  significance 
of  86  cents,  since  their  product  has  that  significance."  But,  is  it  not 
absurd  to  talk  about  the  specific  significance  of  the  4Fi's  or  that 
of  the  sFs's  or  that  of  the  nFs's  ?  Only  an  affirmative  answer  seems 


1  One  condition  on  which  the  dosing  theory  claims  to  be  able  to  build 
would  be  retained.  That  condition  is  the  possibility  of  using  different  com- 
bining proportions. 


374  PRINCIPLES  OF  ECONOMICS  [XXX 

possible.  So  long  as  we  are  dealing  with  a  single  situation  like  the 
one  supposed,  the  very  idea  that  each  kind  of  factor,  the  Fi's  or  the 
F«'s  or  the  F»'s  has  its  own  specific  significance  in  the  process,  in- 
volves a  logical  absurdity. 

But,  now,  this  is  not  the  end  of  the  matter.  It  is  quite  true  that, 
with  no  other  facts  before  us  than  those  contained  in  the  single 
proposition  that  the  4Fi's,  3F»'s  and  nFs's  would  together  produce 
a  product  worth  86  cents,  we  could  not,  with  propriety,  speak  of  the 
specific  significance  of  any  one  of  these  three  factors.  But,  then,  it 
is  quite  incredible  that  these  facts  should  be  the  only  ones  before  us. 
We  should  doubtless  have  many  others  at  our  command,  else  our 
complete  hypothesis  would  be  so  far  from  reality  as  to  have  no 
interest  for  us.  In  particular,  there  would  doubtless  be  many  other 
kinds  of  goods  beside  the  Pi  we  have  supposed,  which  other  goods 
we  were  producing  with  these  same  three  factors,  Fi,  F2,  and  F»; 
and,  in  producing  those  other  kinds  of  goods,  we  should,  in  many 
cases  at  least,  be  using  combinations  of  the  three  factors  different 
from  the  combinations  used  in  producing  Pi.  It  is  in  view  of  this 
change  in  our  way  of  looking  at  the  matter  that  we  are  easily  able 
to  show  that  each  factor  in  joint  processes  really  has  its  own  pe- 
culiar, specific  significance  in  the  productive  process.  That  is,  we 
are  easily  able  to  show  that,  though  the  data  derived  from  the  single 
proposition  concerning  the  production  of  Pi  with  which  we  started 
would  not  warrant  our  imputing  specific  significance  to  each  factor, 
these  data  combined  with  data  derived  from  other  facts  of  the  sit- 
uation, other  productive  operations,  would  do  so — in  short,  if  all  the 
facts  of  the  situation  be  taken  into  account,  each  factor  in  produc- 
tion has  its  own  specific  significance. 

Proof. — Let  us  suppose,  then,  that  we  use  but  three  primary 
factors  as  above,  Fi,  Fi,  and  F3;  that  we  know  on  just  what  goods 
our  stock  of  factors  ought  to  be  expended,  and  just  what  combin- 
ing proportions  ought  to  be  used ;  that  our  productive  processes  are 
all  direct  from  primary  factors  to  consumers'  products;  and  that 
there  are  at  least  three  cases  in  which  the  proper  combinations  are 
different  each  from  the  others.  Let  these  cases  be  as  follows: 
(i)  one  in  which  4Fi's,  3F2's,  and  nFs's  unite  to  produce  a  product, 


XXX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  375 

Pi,  having  a  value  of  86  cents ;  (2)  one  in  which  4Fi's,  ioF2's  and 
2F«'s  unite  to  produce  a  product,  P*,  having  a  value  of  60  cents; 
and  (3)  one  in  which  loFi's,  3F2's,  and  3p3's  unite  to  produce 
Ps,  having  a  value  of  50  cents.  Now,  letting  x,  y,  and  s  represent 
the  unknown  values  or  importances  of  Fi,  p2,  and  Fa,  respectively,  we 
obviously  are  able  to  derive  three  equations  as  follows : 

4-*"  +    3^  -f-  1 12  —  86  cents 

4jr  +  103;  +    22  =  60  cents 

i  cu:  -f-    33;  -f-    32  =  50   cents 

Solving  these  equations  for  the  three  unknowns,  we  get  the  following 
results : 

x  =  2  cents 

y  —  4   cents 

2  •=.  6   cents 

That  is,  in  view  of  the  values  of  the  products  into  which  our  factors 
must  be  put  and  of  the  proportion  in  which  those  factors  must  be 
combined,  if  most  wisely  used,  each  Fi  has  a  value  or  significance  of 
two  cents,  each  F2  a  value  or  significance  of  four  cents,  and  each  Fa 
a  value  or  significance  of  six  cents. 

II 
Meaning  of  Significance  or  Importance  over  the  Whole  Field 

We  have  seen  that,  under  our  hypothetical  conditions,  each  factor 
in  a  joint  productive  process  has  its  own  special  significance.  Before 
going  on  to  maintain  that  the  said  significance  influences  the  price  of 
said  factor,  we  must  remark  on  the  peculiar  character  of  the  sig- 
nificance or  importance  which  has  been  here  affirmed  of  factors,  that 
is,  significance  over  the  whole  Held.  The  point  needing  special  com- 
ment is  that  the  term,  significance,  in  this  connection  has  a  less  con- 
crete meaning  than  in  previous  connections.  Most  frequently  we 
have  meant  by  the  significance  of  an  economic  good  a  significance 
derived  from  the  direct  dependence  of  some  gratification  upon  con- 
trol over  specific  units  of  that  good,  and  which,  therefore,  is  the  same 
as  the  significance  of  that  gratification.  Thus,  if  a  certain  gratifica- 


376  PRINCIPLES  OF  ECONOMICS  [XXX 

tion  of  one's  want  for  fruit  were  dependent  on  possessing  a  par- 
ticular quart  of  berries,  the  significance  of  that  quart  of  berries 
would  be  the  significance  of  that  particular  gratification.  Now, 
strictly  speaking,  such  a  conception  of  significance  is  applicable  only 
to  final  products,  consumption  products ;  but  it  could  without  great 
difficulty  be  applied  to  the  case  of  a  factor  whenever  we  could  isolate 
some  particular  unit  of  some  consumption  good  as  the  specific  eco- 
nomic product  of  said  factor.  The  connection  in  such  a  case  would, 
indeed,  be  indirect,  one  or  more  stages  removed.  But,  after  all,  a 
specific.gratification  would  be  dependent  on  the  particular  unit  of  that 
factor,  and  hence  those  particular  units  would  have  the  significance 
which  attached  to  that  specific  gratification.  Thus,  assuming  that  the 
quart  of  berries  in  our  illustration  above  had  but  one  cost,  fifteen 
minutes'  labor,  then  the  significance  of  that  labor  would  be  the  same 
as  the  significance  of  the  berries,  that  is,  the  significance  of  the  grati- 
fication derivable  from  those  berries. 

Significance  to  the  System. — But,  now,  in  our  present  con- 
nection, such  a  concept  of  significance  is  too  direct,  too  concrete 
The  significance  of  a  factor  the  specific  product  of  which  we  are 
unable  to  isolate  cannot  be  directly  traced  to  the  gratification  deriva- 
ble from  some  particular  consumers'  product,  because  the  course  of 
causation  between  such  factors  and  the  particular  consumption- 
product  cannot  be  traced.  The  different  factors  are  all  thrown, 
so  to  speak,  into  a  vast  organic  system  and  out  of  that  system,  viewed 
as  a  whole,  all  consumers'  goods  are  drawn.  Immediately,  then,  all 
goods  are  the  product  of  the  system ;  and  all  the  services  of  the  fac- 
tors are  services  to  the  system.  As  a  consequence,  the  significances 
of  the  factors  must,  in  the  first  instance,  be  found  in  the  system,  not 
in  products.  In  short,  the  significances  of  factors  cannot  be  traced 
to  the  significances  of  particular  units  of  goods. 

Significance  to  Concrete  Persons. — These  comments,  how- 
ever, should  not  mislead  us.  All  economic  significance,  whether  sig- 
nificance of  products  or  of  factors,  is  ultimately  due  to  the  gratifica- 
tions— advantages — to  be  derived  from  such  products  or  factors  by 
living  human  beings,  not  by  systems.  But,  since  the  product  on 


XXX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  377 

which  the  gratification  of  our  wants  depends  necessarily  comes  to 
us  through  the  system,  that  gratification  necessarily  depends  on  the 
proper,  satisfactory  zvorking  of  the  system.  Hence,  significances 
which  attach  to  the  system  or  to  the  whole  body  of  products  rather 
than  to  specific  products,  are,  after  all,  very  real  significances  for 
each  of  us  as  living  human  beings. 

Ill 

The  Spontaneous  Working  of  Economic  Forces  Tends  to  Give 

Each  Primary  Factor  a  Price  Expressing  Its 

Specific  Significance 

The  preceding  discussion  has  shown  that,  despite  the  fact  that  we 
have  eliminated  in  our  hypothesis  the  possibility  of  ascer&ining 
directly  the  significance  of  factors  in  the  particular  processes  in 
which  they  are  employed,  still  each  has  its  own  specific  significance 
over  the  industrial  field  as  a  whole.  We  must  now  try  to  show  that 
each  one  of  such  factors  tends  to  get  a  price  which  expresses  this 
specific  significance  which  we  have  proved  must  exist.2  The  argu- 
ment which  we  shall  employ  in  maintaining  this  contention  may  be 
summarized  in  the  following  proposition  : 

The  presence  on  the  market  of  an  abnormal  price  for  any  pri- 
mary factor,  that  is  a  price  different  from  one  which  would  ex- 
press the  effective  significance  of  that  factor,  would,  of  itself,  be 
sufficient  to  set  up  a  series  of  reactions  tending  to  replace  said 
abnormal  price  with  one  which  did  express  the  effective  signi- 
ficance of  the  factor  in  question;  and  these  reactions  would  not 
cease  until  the  latter  price  had  been  established. 

In  developing  the  line  of  reasoning  summarized  in  this  proposi- 
tion, our  first  task  is  to  comment  on  the  initial  steps  which  set  up  the 
different  series  of  reactions.  In  general,  these  consist  of  abnormal 
policies  adopted  by  producers  because  of  the  abnormal  price  for  some 
factor  which  we  have  assumed.  Such  abnormal  policies  have  their 


3  Remember  that  our  algebraic  operations  were  used  to  show  merely  that, 
even  under  our  extreme  hypothesis,  each  factor  would  really  have  its  own 
specific  significance.  Those  operations  did  not  show  that  said  significance 
would  determine  the  price  of  said  factor.  This  task  is  yet  to  be  performed. 


378  PRINCIPLES  OF  ECONOMICS  [XXX 

origin  in  the  fact  that  the  abnormal  price  of  the  factor  in  question 
makes  abnormal  (i)  the  comparative  costs  of  producing  different 
goods,  and  (2)  the  comparative  costs  of  using  different  combining 
proportions  in  producing  the  same  goods.  Because  of  these  ab- 
normalities in  cost  due  to  the  assumed  abnormal  price  of  some  factor, 
the  policy  of  producers  would  tend  to  be  made  abnormal  in  a  variety 
of  ways.  In  our  argument,  however,  we  shall  make  use  of  but  two  of 
these,  namely :  ( i )  Abnormal  decisions  in  respect  to  the  goods  to  be 
produced,  and  (2)  abnormal  decisions  in  respect  to  the  combining 
proportions  to  be  used  in  producing  those  goods. 

Comparative  Costs  of  Products  Abnormal. — That  an  abnor- 
mal price  for  a  given  factor  must  alter  and,  therefore,  must  make 
abnormal,  the  comparative  costs  of  producing  different  goods  is 
almost  self-evident.  If,  for  example,  the  price  of  a  given  factor 
were  abnormally  low,  though  this  fact  would  lower  the  cost  of  all 
products  more  or  less,  the  effect  would  be  greater  in  the  case  of 
those  goods  into  which  the  abnormally  cheap  factor  entered  in  larger 
proportions.  Thus,  if  we  suppose  the  third  of  the  factors  used  in 
our  illustration  on  pages  374  and  375,  Fs,  to  have  a  price  of  4  cents 
instead  of  the  normal  one  of  6  cents,  the  cost  of  every  one  of  our 
3  products  would  be  lowered,  Pi  from  86  cents  to  64  cents  or  25  per 
cent ;  Pz  from  60  cents  to  56  cents  or  6  per  cent ;  and  Pa  from  50 
cents  to  44  cents  or  12  per  cent.  On  the  other  hand,  although  an 
abnormally  high  price  for  F3  would  raise  costs  for  each  of  the  three 
products,  it  would  have  more  effect  on  the  goods  into  which  that 
factor  entered  in  larger  proportion.  Thus,  with  a  price  of  8  cents 
for  Fs,  the  cost  of  Pi  would  be  raised  from  86  cents  to  $1.08  or  25 
per  cent,  the  cost  of  Pz  from  60  cents  to  64  cents  or  6  per  cent, 
and  that  of  Pa  from  50  cents  to  56  cents  or  12  per  cent. 

Costs  of  Combining  Proportions  Abnormal. — But  an  abnormal 
price  for  a  given  factor  would  alter  not  only  the  comparative  costs  of 
producing  different  goods,  but  also  the  comparative  costs  of  using 
different  combining  proportions  in  the  production  of  the  same  com- 
modity. Thus,  let  us  suppose  that  a  combination  of  iFi,  iF2,  and 
i4Fa's  would  produce  a  unit  of  our  commodity  Pi  quite  as  well  as  our 


XXXI  PRIMARY  FACTORS  AND  SIGNIFICANCE 


379 


original  combination  of  4Fi's,  3F>'s  and  nF»'s.  At  the  normal  price 
for  Fa's,  which  was  assumed  to  be  6  cents,  this  new  combination 
would  be  shut  out,  since  its  total  cost  would  be  2  cents  plus  4  cents 
plus  84  cents,  or  a  total  of  go  cents,  whereas  the  cost  of  the  original 
combination  was  only  86  cents  (8  plus  12  plus  66).  If,  however,  the 
price  of  one  F3  should  leave  the  normal,  falling  to  4  cents,  the  cost 
of  the  new  combination  would  fall  to  62  cents  (2  plus  4  plus  56), 
while  that  of  the  old  combination  would  fall  to  only  64  cents  (8  plus 
12  plus  44). 

Comparative  Profitableness  Abnormal. — But  it  is  hardly 
necessary  to  say  that  an  abnormality  in  the  price  of  a  factor  which 
lowered  the  comparative  cost  of  producing  a  particular  commodity 
or  of  using  a  particular  combination  would  necessarily  increase  the 
comparative  profitableness  of  producing  that  commodity  or  using  that 
combination.  Further,  this  process  would  reverse  the  positions  of 
two  products  or  two  combinations  as  respects  comparative  profitable- 
ness wherever  the  conditions  were  such  that  the  differences  between 
the  comparative  costliness  of  different  products  and  different  pro- 
ductive combinations  were  slight  differences,  a  condition  which  prob- 
ably obtains  in  the  majority  of  cases. 

Choice  of  Products  and  Combinations  Abnormal. — Finally, 
since  the  original  abnormality  in  the  price  of  one  of  the  factors  tends 
to  reverse  the  positions  of  different  products  and  different  combining 
proportions  in  respect  to  their  profitableness,  it  tends  to  reverse  the 
policies  of  producers  in  respect  to  which  of  two  products  they  will 
produce  and  which  of  two  different  combining  proportions  they  will 
employ.  On  the  one  hand,  an  abnormally  high  price  for  a  given 
factor  will  cause  them  to  produce  less  than  the  normal  amount  of 
goods  which  call  for  a  large  quantity  of  said  factor  and  to  employ  in 
less  than  the  normal  amount  the  particular  combinations  of  factors 
which  contain  the  particular  factor  in  large  quantity.  On  the  other 
hand,  an  abnormally  low  price  for  a  particular  factor  will  cause 
entrepreneurs  to  produce  more  than  the  normal  amount  of  the  goods 
which  call  for  a  large  quantity  of  said  factor  and  employ  to  a  more 
than  normal  extent  the  combinations  of  factors  which  contain  this 


380  PRINCIPLES  OF  ECONOMICS  [XXX 

particular  factor  in  large  quantity.  In  the  former  case,  the  reaction 
just  noted, — that  is,  the  too  scanty  production  of  goods  and  the  too 
scanty  use  of  combinations  which  call  for  large  quantities  of  the 
factor  in  question,  prepares  us  for  the  final  one  to  appear  in  the 
next  paragraph.  In  the  second  case,  however,  one  more  reaction 
precedes  the  final  one.  When  the  abnormally  low  price  of  the  factor 
in  question  has  led  entrepreneurs  to  drain  off  the  supplies  of  that 
factor  to  produce  goods  and  use  combinations  which  were  profitable 
only  because  of  said  abnormally  low  price  it  becomes  inevitable  that 
the  production  of  other  goods  which,  in  view  of  the  situation  as  a 
'whole,  are  needed  'more  than  these  into  which  our  factor  is  supposed 
to  have  gone,  should  fall  below  normal.  That  is,  the  too  low  price  of 
the  factor  in  question  results  in  an  abnormally  small  output  of 
products  having  a  higher  importance. 

Final  Reactions. — We  come  now  to  the  last  step  in  these 
reactions  set  up  by  the  abnormality  in  the  price  of  our  primary  fac- 
tor. First,  what  is  the  final  reaction  in  the  case  of  an  abnormally 
high  price  for  our  factor?  The  answer  is  easy.  Since  a  too  high 
price  for  that  factor  inevitably  results  in  an  abnormally  small  produc- 
tion of  those  goods  and  an  abnormally  small  use  of  those  combina- 
tions in  which  that  factor  plays  a  large  part,  there  comes  to  be  on  the 
market  an  excess  of  this  factor,  with  the  result  that  those  who  supply 
?aid  factor  are  obliged  to  bid  down  the  price  in  order  to  get  a  market 
for  their  commodity.  Accordingly  as  respects  this  case  of  an 
abnormally  high  price  for  a  factor,  we  have  reached  our  goal.  The 
abnormality  in  that  price  inevitably  sets  up  a  series  of  reactions  which 
tend  to  eliminate  said  abnormality :  the  too  high  price  of  the  factor 
is  bound  to  be  its  own  undoing. 

What,  finally,  is  the  end  of  the  series  of  reactions  which  results 
from  an  abnormally  low  price  ?  The  last  reaction  already  noted  had 
brought  us  to  an  abnormally  small  output  of  various  goods  which 
the  situation  called  for,  but  from  which  producers  had  been  drawn 
off  to  produce  goods  the  production  of  which  had  been  made  un- 
usually profitable  by  the  abnormally  low  price  of  the  factor  in  ques- 
tion. It  is  this  decrease  in  the  output  of  goods  really  called  for 
which  brings  on  the  final  reaction.  Such  decrease  in  the  output  of 


XXX]  PRIMARY  FACTORS  AND  SIGNIFICANCE  38r 

these  goods  necessarily  raises  their  marginal  significance ;  this  raises 
their  price;  such  rise  in  price  increases  the  profit  to  be  earned  in 
producing  them;  and  finally  entrepreneurs,  as  a  condition  of  earning 
that  profit,  bid  up  the  price  of  the  factor  which  is  too  cheap. 

To  sum  up  these  reactions  in  a  sentence  we  may  say :  On  the  one 
hand,  an  abnormally  high  price  for  any  factor  necessarily  throws 
out  of  employment  a  greater  or  less  quantity  of  that  factor  and  so 
in  the  end  tends  to  destroy  itself;  on  the  other  hand,  an  abnormally 
low  price  for  any  factor  shifts  production  from  more  important  to 
less  important  commodities,  and  the  reaction  necessary  to  correct 
this  misdirected  production  eliminates  or  tends  to  eliminate  the 
abnormal  price  supposed  to  exist. 

Reactions  Cease  only  with  Price  Normal. — We  have  seen 
that  the  presence  of  a  price  for  a  factor  which  did  not  express  the 
effective  significance  of  that  factor  would,  through  its  influence  on 
the  conduct  of  producers,  set  in  motion  reactions  tending  to  remove 
the  original  cause  of  the  trouble,  the  said  abnormal  price  of  said 
factor.  We  have  only  to  add  that  these  reactions  could  not  cease  till 
they  had  replaced  the  abnormal  price  of  the  factor  with  its  normal 
one,  that  is,  with  one  which  expressed  the  effective  significance  of 
said  factor.  This  is,  of  course,  implicit  in  the  contention  already 
maintained.  Any  departure  from  the  normal  price  of  the  factor 
must  tend  to  set  up  the  reactions  described.  Doubtless  a  large  dis- 
crepancy between  the  normal  price  and  the  actual  price  would  set 
up  the  needed  reactions  more  quickly  and  give  them  greater  energy. 
But  the  existence  of  any  discrepancy,  however  small,  must  tend  to  set 
up  the  reactions  described ;  and  nothing  would  completely  shut  them 
out  except  the  entire  disappearance  of  such  discrepancy. 


CHAPTER  XXXI 

THE  SYSTEM  OF  PRICES  AS  A  WHOLE 

In  the  last  two  chapters  we  have  tried  to  work  out  a  tenable  doc- 
trine as  to  the  processes  by  which  the  prices  of  the  most  funda- 
mental elements  in  the  economic  order — the  primary  factors  or  cost- 
goods — are  determined.  It  now  becomes  our  duty  to  try  to  bring 
these  ultimate  x  processes  into  relation  with  those  more  immediate 
or  superficial  ones  which  are  embodied  in  the  law  of  single  price,  the 
laws  of  supply  and  demand,  the  laws  of  cost,  and  so  on.  In  other 
words,  we  must  try  to  get  some  notion  of  price  determination  as  a 
complete  process,  some  notion  of  the  system  of  prices. 


There  Must  Be  a  Coherent,  Self-Consistent  System  of  Prices 

The  Interdependence  of  All  Prices. — Perhaps  the  most  natural 
introduction  to  an  attempt  to  get  a  bird's-eye  view  of  the  price  sys- 
tem as  a  whole  is  to  make  ourselves  realize  that  there  is  such  a  sys- 
tem. Prices  are  not  a  mere  aggregate  of  unrelated  entities  or  only 
slightly  related  entities.  Instead,  we  should  realize  that,  in  very  im- 
portant senses,  the  prices  of  all  goods  are  interdependent  and  must 
tend  to  form  a  coherent,  self-consistent  system  of  prices.  Obviously 
this  doctrine  is  in  some  degree  explicit  or  implicit  in  our  previous 
study  of  prices.  Thus,  in  saying  that  the  price  of  a  wooden  chair 
is  determined  by  its  cost  of  production,  we  thereby  say  that  there 
is  interdependence  between  the  prices  of  products  and  the  prices  of 
the  cost-goods  entering  into  those  products.  Again,  in  affirming  such 
determination  of  the  price  of  the  chair  by  its  cost,  we  implicitly 
affirm  that  there  is  interdependence  between  the  prices  of  all  products 
from  one  common  cost-good,  such  as  wood  or  steel  or  labor. 


1  Logically  ultimate, 

382 


XXXI]  SYSTEM  OF  PRICES  AS  A  WHOLE  383 

But,  while  the  interdependence  of  prices  has  in  some  degree  been 
brought  out  in  our  previous  study,  it  has  been  so  little  emphasized 
that  one  might  easily  get  the  impression  that  the  determination  of  the 
price  of  each  commodity  is  a  matter  by  itself,  or  anyhow  that  there 
is  no  general,  all-inclusive  interrelationship  among  prices.  In  an 
account  of  final  price  determination,  therefore,  it  is  important  to  lay 
some  stress  on  this  point.  Put  in  a  formal  way,  it  may  be  stated 
as  follows : 

All  prices,  especially  the  prices  of  produced  goods,  are  inter- 
dependent; and  equilibrium  among  the  price-making  forces  can  be 
approximated  only  when  all  prices  have  come  to  form  a  coherent, 
self -consistent  system. 

Cost-Goods  and  Products. — As  already  noted,  two  very  im- 
portant reasons  for  affirming  the  interdependence  of  prices  are  ex- 
plicit or  implicit  in  the  doctrines  which  make  the  prices  of  products 
coincident  with  their  costs  of  production.  In  the  first  place,  this  very 
relationship  of  cost-good  and  product  directly  involves  interdepend- 
ence. If  two  things  have  to  be  equal,  there  must  be  interdependence 
between  them.  This  conclusion  is  unavoidable  whatever  theory  we 
may  hold  as  to  the  direction  of  causation  between  cost-good  and 
product.  If  we  accept  the  doctrine  given  in  Chapter  XXXI  that, 
generally  speaking,  the  value  of  the  cost-goods  is  communicated  to 
the  product,  the  interdependence  of  the  prices  of  the  two  types  of 
goods  is  manifest.  If  we  accept  the  doctrine  which  is  apparently 
held  by  some  writers  that  the  price  of  the  product  always  deter- 
mines the  prices  of  the  cost-goods,  the  result  is  the  same:  the  two 
sets  of  prices  must  coincide,  must  therefore  be  interdependent. 

Common  Intermediate  Cost-Goods. — A  second  reason  for  the 
necessary  interdependence  of  prices,  derived  from  the  principle  that 
the  prices  of  cost-goods  and  products  must  coincide,  is  the  fact  that 
many  products  involve  the  consumption  of  one  common  cost-good. 
Thus,  rails,  girders,  saws,  knives,  razors,  watch  springs,  etc.,  be- 
ing all  made  from  steel,  must  have  their  prices  influenced  by  that 
of  steel  and  at  the  same  rate,  hence  those  prices  must  be  interde- 
pendent. The  price  of  any  one  of  them  could  be  determined  in- 


384  PRINCIPLES  OF  ECONOMICS  [XXXI 

dependently  of  the  others  only  in  case  the  steel  used  in  making  them 
were  sold,  in  the  same  market  at  the  same  time,  for  different  prices 
corresponding  to  its  different  uses.  But  such  a  state  of  things  we 
have  already  shown,  in  the  law  of  Single  Price,  to  be  impossible. 

Common  Primary  Cost-Goods. — But,  admitting  this  point, 
cannot  the  prices  of  all  products  made  from  one  particular  kind  of 
raw  material  be  determined  independently  of  the  prices  of  products 
made  from  other  kinds  of  raw  materials?  For  example,  though  the 
prices  of  rails  could  not  be  determined  independently  of  the  prices 
of  engines,  girders,  saws,  planes,  and  knives,  still  the  prices  of  all 
products  made  from  steel  could  surely  be  determined  independently 
of  the  prices  of  all  products  made  from  lead  or  copper  or  zinc  or 
wood.  On  the  contrary,  this  doctrine  is  scarcely  less  absurd  than 
the  former.  Like  the  steel  knives,  steel  saws,  and  steel  girders  re- 
ferred to  in  our  first  example,  products  made  from  steel  and  products 
made  from  lead,  copper,  and  zinc  also  have  common  sources, — the 
human  labor  of  many  different  kinds  and  the  capital  or  carrying 
power  which  is  required  in  all  the  industries  concerned.  Conse- 
quently if  the  prices  of  products  made  from  steel  were  to  be  deter- 
mined independently  of  the  prices  of  products  made  from  lead  or 
zinc  or  copper,  then  the  different  kinds  of  labor,  the  waiting  power, 
and  the  other  factors  which  constitute  common  sources  for  steel, 
lead,  zinc,  and  copper — would  each  have  to  have  many  different  prices 
in  the  same  market  at  the  same  time,  in  contravention  of  the  Law 
of  Single  Price. 

Different  Goods  Reciprocal  Substitutes. — We  have  seen  that 
the  interdependence  of  the  prices  of  many  goods  anyhow  is  assured 
because  of  the  principle  that  the  prices  of  products  and  cost-goods 
must  coincide.  Other  more  inclusive  reasons  why  there  must  be  in- 
terdependence of  price  grow  out  of  the  fact  that  different  kinds  of 
goods  occupy  toward  one  another  the  relation  of  reciprocal  sub- 
stitutes; if  there  are  serious  obstacles  to  buying  a  particular  good, 
some  other  can  more  or  less  completely  take  its  place.  This  is  con- 
spicuously true  in  the  case  of  groups  of  goods  intended  to  serve  the 
same  general  purpose,  such  as  the  different  means  for  furnishing 


XXXI]  SYSTEM  OF  PRICES  AS  A  WHOLE  385 

illumination,  or  the  different  foods,  methods  of  transportation,  and 
so  on.  As  a  result  of  such  possibility  of  reciprocal  substitution, 
the  demand  schedules  of  these  different  goods  are  interdependent, 
each  one  is  affected  by  changes  in  the  others.  A  change  in  the  price 
of  gas  modifies  the  demand  schedules  of  electric  lighting,  of  kerosene 
oil,  of  candles,  etc. ;  a  change  in  the  price  of  wool  modifies  the  de- 
mand schedule  of  cotton ;  a  change  in  the  price  of  meats  modifies 
the  demand  schedules  of  potatoes,  beans,  etc.  But,  if  the  demand 
schedules  of  different  commodities  are  interdependent,  their  prices 
must  also  be  interdependent ;  since  changes  in  their  demand  sched- 
ules, other  things  being  equal,  must  change  their  prices.  Interde- 
pendence of  prices,  therefore,  follows  as  a  result  of  the  fungibility 
of  different  goods,  the  possibility  of  their  reciprocal  substitution. 

The  particular  ground  of  interdependence  just  brought  out  is 
most  certainly  present  and  most  clearly  seen  in  the  case  of  groups  of 
goods  intended  for  the  satisfying  of  the  same  want.  But  the  same 
statements  apply  in  a  degree  to  almost  all  kinds  of  goods.  In  a  broad 
but  legitimate  meaning  of  the  language,  practically  all  goods  occupy 
toward  one  another  the  relation  of  reciprocal  substitutes.  Each  is 
competing  against  every  other  for  the  opportunity  to  satisfy  our 
wants.  A  rise  in  the  price  of  any  one  tends  to  cause  a  change  in 
the  demand  schedules  for  all  or  many  others.  Changing  their  demand 
schedules,  it  must  of  course  tend  to  change  their  prices.  Thus, 
again,  all  prices  are  interdependent.2 

A  Self-Consistent  System  of  Prices. — We  have  shown  the 
soundness  of  the  first  part  of  our  general  proposition,  which  says 
that  all  prices  are  interdependent.  The  second  part  follows  as  an 
immediate  inference  from  the  first,  and  should  call  for  no  other 
argument.  Since  all  prices  are  interdependent,  are  reciprocally  de- 
termined, reactions  among  them  cannot  cease — equilibrium  cannot  be 
reached — till  they  together  form  a  coherent,  self^consistent  whole. 


2  It  is  hardly  necessary  to  warn  the  student  that  there  is  some  danger  of 
exaggerating  the  importance  of  this  interdependence  of  prices.  It  would 
certainly  be  a  serious  error  to  imagine  that  the  facts  just  brought  out  seriously 
impair  the  value  of  the  principles  of  price  hitherto  presented.  These  facts 
must  rather  be  thought  of  as  qualihcations  of  those  principles,  minor  forces 
modifying  their  effects. 


386  PRINCIPLES  OF  ECONOMICS  (XXXI 

ILLUSTRATIVE  PROBLEMS 

1.  It  is  quite  unsound  to  imagine  that  the  wages  paid  in  a  particular 
coal  mine   or  in  coal   mining  generally   are   determined   independently 
of  wages  in  other  lines  of  industry.     Wages  are  prices,  and,  like  other 
prices,  they  are  bound  to  be  interdependent.     Give  specific  reasons  for 
the  correctness  of  that  statement  in  the  case  of  wages. 

2.  It  has  been  held  by  some  writers  that  almost  any  tax  system,  if 
only  it  is  old  enough,  will  fall  on  the  different  classes  of  citizens  with 
about  the  same  weight  as  would  any  other  system  raising  the  same  amount 
of  revenue.     This  doctrine  is  doubtless  overstated;  still  it  contains  an 
element  of  truth.     Give  the  general  argument  in  support  of  it. 

3.  (a)     "A  protective  tariff  is  a  device  for  taxing  the  consumers  of 
the  commodity  involved  in  order  to  give  big  incomes  to  the  producers  of 
that  commodity." 

(b)  "A  protective  tariff  is  a  device  for  taxing  the  consumers  of  the 
commodity  involved  in  order  to  insure  the  maintenance  of  the  industry 
which  produces  that  commodity." 

Looked  at  broadly,  the  second  statement  is  much  nearer  the  truth. 
Assuming  the  tariff  to  be  kept  constant,  there  is  no  reason  for  expecting 
that  the  producers  of  the  protected  industry  will  reap  exceptional  profits 
therefrom.  Argue  in  support  of  that  statement. 

II 
Price  Determination  as  a  Complete  Process 

We  have  seen  that  all  prices  are  in  greater  or  less  degree  inter- 
dependent and  that  they  tend  to  form  a  coherent,  self -consistent  sys- 
tem of  prices.  We  must  now  attempt  to  get  a  bird's-eye  view  of 
this  system, — to  see  it  as  a  totality,  with  its  parts  articulated.  In  do- 
ing this,  we  shall  set  up  a  series  of  hypotheses,  the  earlier  ones  very 
simple  yet  helping  us  to  understand  some  aspects  of  the  present  order. 

First  Hypothesis:     Only  One  Primary  Factor;  No  Disutility  Cost; 

Many  Products  Wanted;  Both  Demand  and  Supply 

Schedules  Elastic;   Conditions   Static 

We  begin  with  the  hypothesis  that  there  is  but  one  primary  factor  ; 
that  this  has  no  disutility  cost ;  that  many  products  are  wanted ;  that 


XXXI]  SYSTEM  OF  PRICES  AS  A  WHOLE  387 

all  are  increasing-cost  products,  hence  have  elastic  supply  schedules ; 
that  all  demand  schedules  are  elastic ;  and  that  conditions  in  respect 
to  population,  tastes,  methods  of  production,  etc.,  are  substantially 
unchanging. 

Starting  with  such  a  hypothesis,  let  us  suppose  that  the  number- 
less forces  at  work  have  acted  and  reacted  till  they  have  brought 
about  a  condition  of  equilibrium,  that  is,  a  condition  under  which 
all  forces  have  become  exhausted  or  neutralized  by  opposing  forces 
till  there  is  no  longer  any  tendency  to  change  in  the  prices  prevailing. 
What,  now,  in  such  a  state  of  things  will  be  true  with  respect  to  the 
operation  of  our  laws  of  price  and  their  relation  to  one  another? 

All  Price  Laws  Operative. — In  the  first  place,  it  is  evident 
that  in  such  a  state  of  equilibrium  the  results  naturally  worked  out 
by  every  law  of  price  must  have  been  realised.  The  single  primary 
factor  and  the  several  products  must  each  have  but  one  price.  Sup- 
ply and  demand  for  the  single  factor  and  for  each  product  must  have 
come  to  equality.  The  price  of  each  product  must  express  its  mar- 
ginal significance  or  utility.  The  price  of  each  product  must  equal 
its  marginal  cost  of  production.  The  price  of  the  one  primary  factor 
must  express  its  marginal  significance  in  products;  and,  under  our 
present  hypothesis  of  perfect  elasticity  in  all  demand  schedules,  this 
marginal  significance  will  be  found,  not  in  just  one  or  a  few  products, 
but  in  each  product. 

One  Law  Finally  Determinative. — A  second  and  much  more 
important  fact  of  the  situation  would  be  that,  though  the  results  of 
all  the  laws  of  price  would  have  to  be  realized  in  the  state  of  equi- 
librium supposed,  one  of  these  and  only  one  is  finally  determinative. 
The  condition  of  single  price,  of  supply  equalling  demand,  of  price 
coinciding  with  cost  may  be  realized  many  times  temporarily,  pro- 
visionally, without  final  equilibrium's  thereby  having  been  reached. 
But,  just  as  soon  as  the  law  that  the  price  of  the  single  primary  factor 
must  be  such  as  expresses  its  marginal  significance  in  products  has 
been  realized,  equilibrium,  final  equilibrium,  will  have  been  attained. 
This  condition — this  coincidence  of  the  price  of  the  primary  factor 
and  its  marginal  significance — and  this  condition  only,  will  establish 


388  PRINCIPLES  OF  ECONOMICS  [XXXI 

a  definitive,  final,  set  of  prices.  Doubtless  such  a  state  of  things  can 
be  reached  only  after  there  have  taken  place  innumerable  reactions 
in  which  other  forces  and  other  laws  will  have  been  operative.  But 
the  reaction  bringing  about  this  coincidence  of  the  price  of  the  pri- 
mary factor  and  its  marginal  significance  in  products  will  be  the  f.nal 
reaction.  With  the  coming  of  that  price,  equilibrium  will  have  been 
reached,  tendency  to  further  change  will  cease.  It  follows  that,  under 
our  present  hypothesis,  the  marginal  significance  of  products — 
viewed  as  the  determinant  of  the  price  of  the  single  primary  factor — 
must  be  conceived  as  the  ultimate  determinant  of  the  prices  of  prod- 
ucts. But,  in  interpreting  this  proposition,  we  must  not  fail  to  bear 
in  mind  the  phrase  in  italics.  The  marginal  significance  of  products 
is  the  final  determinant  of  the  prices  of  products  only  when  viewed 
as  the  determinant  of  the  price  of  the  single  primary  factor.  But  the 
clearing  up  of  this  point  must  wait  for  the  statement  of  our  next 
hypothesis. 

Other  Laws  Subordinate. — As  a  complement  to  the  point 
last  made,  we  have  to  note  that,  under  our  present  hypothesis,  the 
principles  or  laws  of  price  other  than  the  one  affirming  the  coincidence 
of  the  price  of  the  primary  factor  and  its  marginal  significance,  are 
little  more  than  instrumentalities  through  which  said  coincidence 
is  established  and  through  which  the  domination  of  the  whole  situa- 
tion by  the  marginal  significance  or  utility  of  products  is  assured. 
The  principles  of  single  price  and  of  supply  and  demand  are  opera- 
tive every  moment,  responding  to  every  slightest  change  in  condi- 
tions, while  the  final  equilibrium  is  being  worked  out.  The  principle 
of  cost  lags  a  little  behind,  but  only  a  little.  Together  they  are  in- 
suring that  equilibrium  cannot  come  till  the  finally  determinative 
condition — the  coincidence  of  the  price  of  the  primary  factor  and 
its  marginal  significance — is  realized. 

ILLUSTRATIVE  PROBLEM 

"The  law  of  single  price  tends  to  insure  the  domination  of  marginal 
significance  over  the  entire  stock  of  any  single  commodity;  the  laws 
of  cost  tend  to  insure  such  domination  over  the  whole  field — as  between 
different  commodities."  Defend  that  statement. 


XXXI]  SYSTEM  OF  PRICES  AS  A  WHOLE  389 

Second  Hypothesis :    Same  as  Before ;  but  Most  Demand  Schedules 

Inelastic 

We  now  make  a  slight  change  in  our  hypothesis  in  order  to  bring 
out  unmistakably  the  fact  that  the  marginal  significance  of  products 
was  the  final  determinant  of  prices  only  when  viewed  as  fixing  the 
price  of  the  primary  factor.  This  doctrine  was  indeed  implicit  in  the 
case  embodied  in  the  preceding  hypothesis,  and  has  already  been 
noted.  But,  under  that  hypothesis,  we  could  not  easily  make  the 
point  clear.  As  long  as  all  demand  schedules  are  perfectly  elastic, 
the  price  of  every  product  will  coincide  with  its  own  marginal  sig- 
nificance, so  that  we  are  in  danger  of  fancying  that  the  marginal 
utility  of  products  directly  determines  the  prices  of  products  with- 
out reference  to  the  marginal  significance  of  the  primary  factor.  In 
fact  some  writers  who  have  done  much  to  establish  the  correct  doc- 
trine have  more  than  once  carelessly  spoken  as  if  the  price  of  each 
product  were  determined  by  its  own  marginal  significance  only.3 
The  unsoundness  of  this  view  is  easily  seen  when  we  change  our 
hypothesis  so  as  to  make  some  of  our  demand  schedules  inelastic. 

To  be  quite  specific,  let  us  suppose  that  only  two  of  our  demand 
schedules  are  elastic,  those  of  the  marginal  and  first  extra-marginal 
products;  that  the  marginal  significances,  and  so  the  marginal  de- 
mand prices,  of  the  supra-marginal  products  are  all  much  above  their 
marginal  cost  of  production ;  and  that  there  are  no  extra- marginal 
demands  for  these  products.  Under  this  hypothesis,  the  competition 
of  producers  would  bring  the  prices  of  all  supra-marginal  products 
down  to  their  cost  of  production,  that  is,  to  figures  below  their  mar- 
ginal significances.  In  other  words,  the  prices  of  these  supra-mar- 
ginal products  would  not  even  coincide  with  their  marginal  signifi- 
cances. Those  marginal  significances,  therefore,  could  not  be  credited 
with  fixing  their  prices.  It  is  only  the  marginal  significance  of 
the  marginal  product  which  figures  in  the  process.  But  even  this  is 
not  the  end  of  the  matter.  This  highly  important  thing,  the  marginal 
significance  of  the  marginal  product,  could  not  be  determined  in- 
dependently of  the  quantity  of  the  primary  factor  available.  Had 


1  Writers  of  the  Austrian  school.     See  Note  6,  Appendix. 


390  PRINCIPLES  OF  ECONOMICS  [XXXI 

there  been  more  of  that  factor,  more  products  could  have  been  pro- 
duced, and  so  the  marginal  significance  of  the  marginal  product  would 
have  been  lower ;  had  there  been  less  of  that  factor,  the  opposite  re- 
sult would  have  been  reached.  It  was  possible,  therefore,  to  reach 
final  equilibrium  only  when  the  marginal  significance  of  the  marginal 
product  had  communicated  itself  to  the  primary  factor  and  brought 
the  price  of  said  factor  into  coincidence  with  that  significance.  That 
is,  as  affirmed  above,  the  real  condition  of  final  equilibrium  is  not 
the  coincidence  of  the  price  of  each  product  with  its  own  marginal 
significance,  but  rather  the  coincidence  of  the  price  of  the  primary 
factor  with  its  marginal  significance  as  determined  by  the  marginal 
significance  of  the  marginal  product, 

In  order  to  make  this  rather  difficult  matter  as  definite  as  pos- 
sible, we  may  summarize  the  doctrine  applicable  to  our  present 
hypothesis  in  the  four  following  propositions : 4 

(1)  The  marginal  significance  of  the  marginal  product  having 
been  determined,  determines  the  price  of  that  product ; 5 

(2)  The  price  of  the  marginal  product  having  been  determined, 
determines  the  price  of  each  unit  of  the  primary  factor  entering 
into  that  product; 

(3)  The  price  of  a  unit  of  the  primary  factor  entering  into 
the  marginal  product  having  been  determined,  determines  the  price 
of  all  other  units  of  that  factor ;  and 

(4)  The  price  of  all  units  of  the  primary  factor  having  been 
determined,  determines  the  prices  of  the  supra-marginal  products. 

Here  the  logical  starting  point  of  causation  is  the  marginal  signifi- 
cance of  the  marginal  product ;  but  it  is  such  a  starting  point  because 
it  fixes  the  price  of  the  primary  factor,  and  through  it  of  all  products. 
Under  our  first  hypothesis  the  case  seems  otherwise  because  the 
price  of  every  product  coincides  with  its  own  marginal  significance. 
But  this  arises  from  the  accidental  circumstance  that  all  products 
have  perfectly  elastic  demand  schedules.  The  fact  that,  when  this 
condition  is  altered,  final  price  determination  still  goes  on  without 
the  necessity  of  any  correspondence  between  the  prices  of  the  supra- 


4  It  may  be  worth  the  student's  while  to  go  over  tne  diagrammatic  presenta- 
tion of  this  case  in  Note  7  of  the  Appendix. 
8  See  Note  8  of  the  Appendix. 


XXXI]  SYSTEM  OF  PRICES  AS  A  WHOLE  391 

marginal  products  and  their  marginal  significances  shows  that  the 
really  essential  thing  is  the  coincidence  of  the  marginal  significance  of 
products  in  general  with  the  price  of  the  single  primary  factor.6 

ILLUSTRATIVE  PROBLEM 

If  we  ignore  the  influence  of  disutility,  we  have  to  say  that,  as  re- 
spects the  course  of  causation  between  cost-goods  and  products,  this 
runs  from  the  former  to  the  latter  in  the  case  of  individual  products,  but 
from  the  latter  to  the  former  in  the  case  of  products  taken  as  a  whole. 
Explain  what  is  meant  and  show  why  it  is  true. 

Third  Hypothesis:     Same  as  Last  with  Disutility  Cost  Added 

Our  hypothesis  up  to  this  point  has  involved  the  use  of  a  single 
primary  factor  of  which  we  have  a  fixed  amount,  or  output.  We 
now  modify  that  hypothesis  so  as  to  make  the  supplying  of  the  pri- 
mary factor  dependent  on  human  consent,  and  involving  a  dis- 
utility, thus  giving  variability  to  the  quantity  supplied.  The  change 
in  our  analysis  which  this  change  in  the  hypothesis  makes  necessary, 
is  easily  anticipated  in  view  of  the  discussion  on  pages  361-363. 
The  price  of  the  primary  factor  must  be  such  as  expresses  a  signifi- 
cance at  least  as  great  as  the  marginal  disutility  involved  in  supplying 
that  factor;  and,  of  course,  the  prices  of  products  must  be  high 
enough  to  justify  such  a  price  for  the  primary  factor.  This  does  not 
mean  that  the  price  of  the  single  primary  factor  is  no  longer  coinci- 
dent with  the  marginal  significance  of  its  marginal  product,  but 
that  said  price  must  also  be  coincident  with  the  marginal  disutility 
of  supplying  said  primary  factor.  The  final  condition  of  equilibrium 
among  the  price-making  forces  is  a  price  for  each  unit  of  the  primary 
factor  which  fulfils  both  these  conditions.7 


9  An  interesting  variation  from  our  last  hypothesis  would  be  one  in  which 
the  demand  schedule  of  even  the  marginal  commodity  was  discontinuous,  so 
that  the  marginal  significance  of  this  product  was  separated  by  a  considerable 
interval  from  its  first  extra-marginal  one,  and  at  the  same  time  it  was 
separated  by  a  considerable  interval  from  the  highest  significance  of  the  next 
possible  product  wanted.  Under  this  hypothesis  the  decisive  factor  would 
be,  not  necessarily  the  marginal  significance  of  products,  but  a  significance 
not  higher  than  that  marginal,  and  not  as  low  as  the  first  extra-marginal  one. 

T  For  the  diagrammatic  presentation  of  this,  see  Note  9  of  the  Appendix. 


392  PRINCIPLES  OF  ECONOMICS  [XXXI 

Fourth  Hypothesis:    the  General   Situation  of  Real  Life:    Many 

Factors,   Some  Fixed,  Some  Variable  in  Amount,   Some 

Having  a  Disutility  Cost ;  Some  Demand  Schedules 

Elastic,  Some  Inelastic 

The  conditions  of  real  life  are,  of  course,  vastly  more  complicated 
than  any  of  our  previous  hypotheses — quite  too  complicated,  doubt- 
less, to  permit  a  really  adequate  statement  of  the  processes  of  final 
price  determination  under  those  conditions.  Nevertheless,  it  may 
perhaps  be  worth  while  to  summarize  in  a  general  statement  the  ac- 
count of  this  matter  which  naturally  follows  from  the  doctrines  with 
respect  to  the  prices  of  primary  factors  which  were  laid  down  in 
Chapters  XXVIII  to  XXX,  and  from  the  conclusions  reached  for 
the  highly  simplified  hypotheses  which  we  have  just  considered. 

Summary. — Supposing  static  conditions  and  the  perfect  free- 
dom of  competition  postulated  in  economic  theory  to  be  realized, 
equilibrium — disappearance  of  all  tendency  to  further  change — can 
come  only,  and  then  must  come,  when  the  price  of  each  primary 
factor  is  brought  into  substantial  coincidence  with  a  significance  not 
higher  than  its  marginal  one  and  not  as  low  as  its  first  extra-marginal 
one,  and,  if  said  factor  involves  a  disutility,  into  coincidence  with 
a  disutility  as  great  as  the  marginal  disutility  of  supplying  said  pri- 
mary factor  and  not  as  great  as  the  first  extra-marginal  one.  When 
that  equilibrium  is  reached,  the  price  of  each  product  having  a  per- 
fectly elastic  demand  and  supply  schedule  will  be  one  which  ex- 
presses its  marginal  significance  and  equals  its  marginal  cost;  the 
price  of  each  product  having  an  elastic  supply  schedule  but  an  in- 
elastic demand  schedule  will  be  one  which  equals  its  marginal  cost 
and  is  likely  to  be  one  which  is  below  its  marginal  significance, 
though  it  may  coincide  with  that  significance ;  and  the  price  of  each 
constant-cost  product  must  be  one  which  equals  its  cost  of  produc- 
tion and  coincides  with  its  marginal  significance,  if  at  all,  only 
because  that  significance  adjusts  itself  to  a  price  determined  by  cost. 


CHAPTER  XXXII 

PRINCIPLES  GOVERNING  THE  MONEY  STANDARD 

The  preceding  chapter  brought  to  a  conclusion  our  discussion  of 
that  broad  division  of  Economics  known  as  Exchange.  Before  finally 
dismissing  this  subject,  however,  we  shall  find  it  useful  to  give  some 
further  attention  to  the  study  of  Money.  Money,  as  we  know,  is 
the  medium  of  exchange;  and  as  preliminary  to  the  treatment  of 
exchange,  we  set  forth  in  Chapter  XIV  some  of  the  more  simple 
and  obvious  truths  concerning  Money.  But  now,  with  a  thorough 
study  of  Exchange  as  a  whole  behind  us,  it  becomes  possible,  as  also 
necessary  and  proper,  to  make  a  deeper  investigation  of  the  medium 
by  which  it  is  conducted,  and  to  present  the  more  essential  principles 
governing  that  medium.  In  this  chapter  we  take  up  the  principles 
governing  the  money  standard. 

The  monetary  standard,  the  student  will  remember,  is  that  some- 
thing which  fixes  the  significance  or  value  of  the  money  unit.  Thus  in 
the  United  States,  25.8  grains  of  gold,  nine-tenths  fine,  fixes  the  value 
of  the  dollar ; — whatever  value  may  at  any  time  attach  to  25.8  grains 
of  gold,  that  same  value  will  attach  to  one  dollar.  Now  this  very 
definition  shows  that  the  monetary  standard  is,  in  an  important  sense, 
the  foundation  of  the  whole  system,  and  that  a  change  from  one 
standard  to  another,  or  even  mere  liability  to  change,  may  carry 
with  it  the  threat  of  serious  harm.  Further,  experience  has  shown 
that  it  is  by  no  means  an  easy  task  to  insure  that  such  changes  will 
not  take  place.  The  monetary  standard  has  many  times  been  dis- 
pl^ed  in  spite  of  the  utmost  preventive  efforts  a  government  could 
make;  and,  in  fact,  governments  themselves  have  more  than  once 
through  mistaken  legislation  inadvertently  brought  about  the  very 
displacement  which  they  were  trying  to  avoid.  Manifestly,  then, 
it  is  quite  important  that  we  should  know  the  natural  laws  which  con- 
cern the  monetary  standard  in  order  that  we  may  be  able  rightly  to 
manage  that  standard. 

393 


394  PRINCIPLES  OF  ECONOMICS  [XXXII 

These  principles  may  be  grouped  in  two  classes:  (i)  those 
concerned  with  the  immediate  standard,  standard  money,  which  di- 
rectly, immediately,  fixes  the  value  of  the  money  unit,  and  (2)  those 
concerned  with  the  ultimate  standard  or  the  something  which  fixes 
the  value  of  standard  money  itself,  and,  in  doing  so,  finally  fixes  the 
value  of  the  money  unit.1 

I 
Defining  and  Determining  Standard  Money 

The  first  principle  to  be  laid  down  with  respect  to  standard 
money  is  the  following : 

Principle  I.  The  standard  money  of  any  system  must 
be  a  money  which  is  at  par  and  which  has  its  value  fixed 
independently  of  its  relations  to  other  moneys. 

The  proposition  that  standard  money  must  be  a  money  which  is 
at  par  is  hardly  more  than  a  corollary  from  the  definition  of  standard 
money. 

Standard  money  is  the  immediate  standard  of  the  system, 
the  money  which  immediately  determines  what  the  money  unit  is 
worth.  To  it,  the  money  unit  is  anchored.  Its  value  is  the  value 
given  to  the  unit.  But,  plainly,  we  cannot  say  of  a  given  money  that 
it  fixes  the  value  of  the  money  unit  unless  a  unit  of  that  money  has 
the  same  value  as  the  money  unit  it  is  said  to  fix.  Thus  we  cannot 
regard  gold  coin  as  the  standard  money  of  the  United  States  if  we 
find  that  ten-dollar  gold  pieces  are  worth  eleven  dollars  each ;  for, 
in  that  situation,  some  other  money  worth  ten-elevenths  as  much 
as  gold  must  really  be  fixing  the  value  of  one  dollar.  No  money 
which  has  a  value  above  or  below  the  value  of  the  unit  can  be  fixing 
the  value  of  fhat  unit. 

We  have  just  seen  that  the  standard  money  must  be  one  which  is 
at  par.  But  we  commonly  find  two  or  more  moneys  fulfilling  this 
condition, — and  which  one  of  the  money  at  par  will  then  be  standard? 
This  question  is  answered  by  the  second  part  of  our  principle.  The 


1  See  pages  165,  166. 


XXXII]  THE  MONEY  STANDARD 


395 


standard  money  is  that  one  of  the  par  moneys  which  has  its  value 
fixed  independently  of  the  other  moneys.  In  most  cases  the  sound- 
ness of  this  contention  is  evident  enough.  Thus,  in  our  system,  gold 
coin  is  firmly  anchored  to  the  metal  contained  in  it, — has  its  value 
fixed  by  that  metal  quite  without  regard  to  the  values  of  the  other 
moneys.  On  the  other  hand,  the  values  of  treasury  notes,  bank 
notes,  and  small  silver  have  no  sort  of  relation  to  the  value  of  the 
material  in  them,  but  are  kept  equal  to  that  of  gold  coin  by  being 
made  directly  or  indirectly  exchangeable  for  gold  coin.  Manifestly, 
then,  as  between  gold  coin  and  the  other  moneys  named,  the  former 
is  the  standard :  it  is  the  thing  which  determines',  they  are  things 
which  are  determined. 

The  case  of  a  par  money  which  is  not  kept  either  directly  or  in- 
directly convertible  with  gold  coin  is  not  so  plain ;  but  the  conclusion 
must  be  the  same.  Such  a  case  is  illustrated  in  most  countries  by 
small  silver  which  is  not  redeemable,2  and,  in  this  country,  by  silver 
dollars.  No  institution  is  bound  to  redeem  these  coins  in  gold  or 
its  equivalent.3  Further,  the  metal  in  the  coins  is  much  less  valuable 
than  gold  coin,  and  is  changing  in  value,  as  measured  in  gold,  every 
day. 

Yet  all  the  time  these  silver  coins  remain  just  equal  in  value  to 
gold  coin.  Just  why  they  do  so  is  a  problem  with  which  we  are  not 
here  concerned.  Here  we  are  asking:  Which  of  these  two  is 
standard  money  ?  Which  is  principal  and  which  subordinate  ?  Which 
determines  and  which  is  determined?  Surely  there  can  be  but  one 
answer.  The  gold  coin  is  fixed  in  its  position,  being  anchored  to 
the  metal  it  contains,  while  the  silver  coin,  showing  no  constant 
relation  to  the  metal  in  it,  is  free  to  move.  Hence,  unless  their 
equality  of  value  is  to  be  attributed  to  mere  coincidence,  and  surely 
this  is  out  of  the  question,  we  must  conclude  that  the  value  of  the 
sirVer  coin  adjusts  itself  to  that  of  the  gold  coin, — is  determined  by 
that  of  the  gold  coin.  Gold  coin,  therefore,  the  money  which  has 
its  value  independently  determined,  is  established  as  the  standard 
money. 


3  It  is  redeemable  in  this  country. 

3  The  United  States  Treasury  would  probably  undertake  to  do  so,  if  they 
became  less  valuable  than  gold. 


396  PRINCIPLES  OF  ECONOMICS  [XXXII 

ILLUSTRATIVE  PROBLEMS 

1.  In  the  United  States  in  1870,  gold  coin  was  worth  $1.21  per  dol- 
lar, silver  coin  $1.23  per  dollar,  and  greenbacks  $1.00  per  dollar.     Which, 
if  any,  must  have  been  standard  money? 

2.  For  several  weeks  during  the  panic  of  1837  coined  money,  whether 
silver  or  gold,  was  at  a  premium  of  from  2  to  4  per  cent,  while  bank 
notes  were  at  par.     Which,  if  any,  must  have  been  standard  money? 

3.  Add  to  the  first  problem  that  in  1870  national  bank  notes  were 
worth  $1.00  per  dollar  and  were   redeemable   in   greenbacks.     Which 
money,  under  this  condition,  must  have  been  standard  money? 

4.  Supposing  that  all  kinds  of  money  are  at  a  premium,  only  bank 
credit  in  the  form  of  checks  being  at  par,  what  then  would  be  standard 
money  or  the  immediate  standard? 

Our  first  principle  has  given  us  little  more  than  a  rule  for 
recognising  standard  money.  The  second  gives  us  one  of  the  most 
important  laws  determining  what  particular  money  occupies  this 
place. 

Principle  II.  //  among  those  moneys  in  any  system 
which  are  a  valid  tender  in  the  payment  of  debts,  differ- 
ences of  exchange  value  arise,  the  cheapest  of  such  valid 
tender  moneys  establishes  itself  as  the  standard  money,  and 
the  rest  go  to  a  premium. 

A  good  illustration  of  this  principle  is  found  in  the  monetary 
history  of  1870.  At  that  time  paper  money,  gold  coin,  and  silver  coin 
showed  differences  in  value,  measured  in  paper,  as  follows:  Gold 
was  worth  21  cents  more  than  paper,  and  silver  was  worth  2  cents 
more  than  gold.  These  differences  could  have  manifested  them- 
selves in  any  one  of  at  least  three  ways:  (i)  paper  might  have  been 
quoted  at  $i,  gold  at  $1.21,  and  silver  at  $1.23,  or  (2)  gold  might 
have  been  quoted  at  $i,  silver  at  $1.02,  and  paper  at  $.82;  or  (3) 
silver  might  have  been  quoted  at  $i,  gold  at  $.98  and  paper  at  $.81. 
If  the  first  hypothesis  had  been  realized,  it  can  be  seen  by  reference 
to  Principle  I  that  paper  would  have  been  the  standard  money;  if, 


XXXII]  THE  MONEY  STANDARD  397 

instead,  the  second  hypothesis  had  been  realized,  gold  would  have 
been  the  standard  money;  finally,  if  the  third  hypothesis  had  been 
realized,  silver  would  have  occupied  the  place  of  honor.  In  fact, 
the  first  hypothesis  was  realized ;  and  the  natural  law  which  insured 
that  it  would  be  is  the  one  stated  in  our  second  principle.  The 
cheapest  of  these  legal  tenders  was  bound  to  establish  itself  against 
the  rest. 

The  proof  of  this  principle  is  relatively  simple.  By  hypothesis 
all  the  moneys  in  question  are  valid  tenders  for  debts.  Under  that 
condition  which  will  be  the  standard  money  for  debts?  If  I  have 
a  right  to  pay  my  debts  with  either  of  two  moneys,  one  of  which 
is  worth  three  cents  more  than  the  other,  which  will  I  naturally 
choose?  The  cheaper,  of  course.  And  what  I  would  naturally  do, 
experience  proves  that  debtors  generally  do.  It  follows  then  that 
the  cheapest  of  two  or  more  valid  tenders  will  be  the  standard  money 
of  debts. 

Secondly,  for  the  sake  of  convenience  in  business  transactions 
the  standard  money  of  debts  and  that  of  prices  must,  if  possible,  be 
the  same.  One  can  imagine  the  inexpediency  of  having  in  business 
one  meaning  for  the  dollar  in  debts,  and  another  for  the  dollar  in 
prices.  A  grocer  fixing  the  prices  of  his  goods  in  one  kind  of 
dollar,  while  his  note  to  the  jobber  was  in  another  sort  of  dollar, 
would  meet  serious  inconveniences;  so  he  surely  would  not  conduct 
business  in  this  way  unless  obliged  to.  But,  thirdly,  he  will  not  be 
obliged  to  do  this,  because  the  standard  money  for  debts  and  the 
standard  money  for  prices  naturally  draw  together  and  become  one. 
The  standard  money  of  debts  is  fixed  by  natural  law  as  the  cheapest 
of  all  the  valid  tenders,  and  this  result  men  cannot  change,  save 
under  very  exceptional  circumstances.  But  the  standard  money  of 
prices,  on  the  other  hand,  is  determined  wholly  by  the  choice  of  the 
individual  dealer.  He  may  freely  rate  his  goods  in  gold  dollars  or 
silver  dollars,  or  greenback  dollars,  or  even  pounds  or  marks  if  he 
desires.  It  is  accordingly  possible  for  the  standard  money  of 
prices  to  adjust  itself  to  the  standard  money  of  debts;  and  since, 
as  we  have  already  seen,  such  an  adjustment  is  for  business  reasons 
highly  desirable,  it  will  inevitably  be  brought  about.  In  a  word,  the 
cheapest  of  the  valid  tenders  becomes  not  only  the  standard  for 


398  PRINCIPLES  OF  ECONOMICS  [XXXII 

debts   but   also   the   standard    for   prices — the   standard   money   in 
general. 

Three  special  applications  of  the  principle  just  established  give 
us  three  corollaries  of  that  principle  which  have  played  a  part  of 
very  great  importance  in  the  monetary  history  of  modern  times. 
Those  corollaries  are  as  follows: 

Corollary  i.  //  two  \metallic  moneys  are  freely  coined 
and  full  legal  tender  at  a  coinage  ratio  different  from  the 
market  ratio,  the  money  coined  from  the  overrated  metal 
will  establish  itself  as  the  standard  money. 

Corollary  2.  If,  in  the  case  of  a  legal  tender  circulating 
note  which  has  hitherto  been  kept  redeemable  in  what  has 
hitherto  been  standard  money,  a  suspension  of  payments 
takes  place,  such  legal  tender  note  will  almost  certainly  estab- 
lish itself  as  standard  money. 

Corollary  3.  //  any  form  of  credit  money  or  money 
substitute  ceases  to  be  redeemable  in  standard  money  or  its 
equivalent,  and,  though  not  a  true  legal  tender,  is  made  in 
effect  a  valid  tender  in  payment  of  debts  by  any  set  of  cir- 
cumstances, such  money  or  money  substitute  will  for  the 
time  being  usurp  the  place  of  standard  money. 

To  illustrate  the  first  of  these  corollaries,  suppose  that,  when 
i  ounce  of  gold  is  worth  on  the  market  16  ounces  of  silver,  the 
government  mint  treats  i  ounce  of  gold  as  worth  only  15  ounces 
of  silver,  putting  into  each  silver  coin  less  metal  than  is  needed, 
considering  the  market  value  of  the  two  metals.  The  mint  thus 
treats  silver  as  worth  more  than  it  really  is;  in  technical  language, 
it  overrates  silver.  Under  these  conditions,  each  silver  coin  will  be 
worth  less — it  will  be  cheaper  money — than  the  corresponding  gold 
coin.  Hence  it  follows  from  Principle  II  that  the  silver  coin  will 
assume  the  place  of  standard  money. 

The  second  corollary,  relating  to  the  behavior  of  legal  tender 
circulating  notes,  offers  no  serious  difficulty.  So  long  as  such  notes 


XXXII]  THE  MONEY  STANDARD  399 

are  kept  redeemable  in  standard  money,  they  of  course  will  be 
worth  as  much  as  standard  money.  When,  however,  the  issuer  of 
the  notes  suspends  payment  on  them,  their  value  inevitably  declines, 
because,  although  people  may  expect  them  to  be  again  made  re- 
deemable at  some  future  time,  they  are  not  willing  to  give  as  much 
for  a  probable  future  payment  as  for  a  certain  present  one.  But 
when  notes  with  the  faculty  of  legal  tender  become  less  valuable 
than  the  money  which  has  hitherto  been  standard  money,  this  fact 
brings  into  operation  Principle  II, — that  is,  these  notes  displace  the 
money  hitherto  standard,  and  themselves  usurp  its  office. 

The  circumstance  alluded  to  in  the  third  corollary  has  repeatedly 
arisen  in  our  history  when  a  concerted  suspension  of  payment  on 
their  notes  by  practically  all  banks  has  led  the  general  public  by 
tacit  consent  to  treat  those  notes  as  a  valid  tender  for  debts.  As  a 
result,  the  notes  behaved  as  if  they  were  a  true  legal  tender — in  other 
words,  Corollary  2  was  brought  into  operation. 

In  a  similar  way,  bank  credit,  deposit  currency,  as  it  is  often 
called,  has  more  than  once  been  made  the  standard  money  by  a 
concerted  refusal  of  banks  to  pay  in  any  form  of  money.  At  such 
times,  the  public  has  come  to  accept  bank  credit  as  a  valid  tender 
for  debts,  thus  making  bank  credit  the  immediate  standard,  while 
all  forms  of  money  proper  went  to  a  premium. 

ILLUSTRATIVE  PROBLEMS 

1.  In  the  United  States  in  1830,  both  silver  and  gold  were  freely 
coined  at  a  ratio  of  15  to  i,  when  the  market  ratio  was  15.8  to  i. 

(a)  Which  metal  did  the  mint  overrate?     Explain  carefully. 

(b)  Which  of  the  two  moneys,  if  any,  must  have  been  standard 
money  ? 

2.  In  1830  France  had  a  system  similar  to  ours  but  its  ratio  was 
15.5  to  i. 

Answer  the  same  questions  for  it  as  for  the  United  States  under  i. 

3.  Why  did  the  United  States  have  the  greenback  as  its  standard 
money  between  1862  and  1879? 

4.  In  1717  the  British  government  decreed  that  a  gold  guinea  should 
be  treated  as  the  equivalent  of  21  silver  shillings;  though,  judged  by  the 


400  PRINCIPLES  OF  ECONOMICS  [XXXII 

bullion  in  them,  the  guinea  was  worth  20^/2  shillings.     Which  must  have 
become  standard  money  ?     Explain. 

5.  In  the  panic  weeks  of  1837,  bank  notes  were  the  standard  money. 
(See  Problem  2,  page  396.)  How  do  you  explain  it? 

II 
Defining  and  Determining  the  Ultimate  Standard 

Thus  far  our  discussion  has  been  concerned  with  standard  money 
and  the  laws  governing  it.  Two  other  principles  of  considerable 
importance  have  to  do  with  defining  and  determining  the  ultimate 
standard.  The  first  of  these  is  the  following: 

Principle  III.  //  by  any  process  whatsoever  the 
standard  money  is  kept  constantly  equal  in  value  to  a  definite 
quantity  of  some  outside  commodity  or  group  of  commodi- 
ties, such  commodity  or  group  of  commodities  constitutes 
the  ultimate  standard  of  the  system. 

This  principle  can  perhaps  be  best  illustrated  by  imagining  a 
system  in  which  there  was  no  metallic  money,  some  kind  of  paper 
money  being  the  standard  money,  but  in  which  that  paper  money  was 
all  the  time  kept  equal  in  value  to  a  certain  amount  of  gold  or  silver 
or  some  other  outside  substance.  In  such  a  system,  the  principle 
tells  us,  the  gold  or  silver  or  other  outside  substance  to  which  the 
standard  money  was  kept  equal  in  value  would  constitute  the  ulti- 
mate standard. 

As  a  matter  of  fact,  this  particular  method  of  realizing  the 
condition  indicated  in  our  principle  is  not  actually  employed,  though 
some  very  able  economists  have  favored  it.  The  plan  generally 
pursued  is  to  have,  as  our  standard  money,  coins  made  of  the  very 
metal  which  we  wish  to  use  for  our  standard,  in  our  own  case,  gold. 
These  coins  we  keep  equal  in  value  to  the  quantity  of  gold  (25.8 
grains)  desired  for  our  ultimate  standard  by  maintaining  two  condi- 
tions which  insure  this  result :  ( i )  the  metal  gold  has  free  and 
gratuitous  coinage — the  mint  must  turn  into  coin  of  full  weight 
without  substantial  charge  whatever  gold  is  offered;  and  (2)  under 


XXXII]  THE  MONEY  STANDARD  401 

ordinary  conditions,  free  inciting  of  gold  coin  is  permitted.  When 
these  conditions  are  realized,  it  is  plainly  impossible  that  the  coin 
and  the  metal,  being  practically  interconvertible,  should  have  differ- 
ent values.  No  one  would  give  more  for  the  coin  than  for  the  metal, 
since  he  could  have  that  metal  turned  into  coin  without  charge ;  so  he 
would  not  give  more  for  the  metal  than  for  the  coin,  since  he  could 
at  will  turn  the  coin  into  the  metal  by  melting  it. 

In  the  above  illustration  of  our  principle,  we  supposed  that  a 
certain  amount  of  gold  was  chosen  as  the  ultimate  standard.  But, 
of  course,  some  other  metal,  for  example  silver,  may  be  chosen,  or 
something  not  a  metal,  say,  wheat,  or  a  group  of  things  made  up 
of  many  items :  a  ton  of  coal  plus  10  yards  of  cotton  plus  100  pounds 
of  flour,  etc.  A  standard  of  the  latter  sort  has  been  advocated 
by  many  able  men  and  is  commonly  known  as  a  multiple  standard. 
But,  whatever  the  particular  thing  or  things  chosen,  the  idea  is  the 
same:  if  there  is  something  outside  the  standard  money  which  fixes 
the  value  of  that  standard  money,  that  something  is  the  ultimate 
standard. 

The  principle  needs  little  argument  to  establish  its  truth,  since 
it  is  little  more  than  the  corollary  from  the  definition  of  the  ultimate 
standard.  The  ultimate  standard  is  the  something  behind  the  im- 
mediate standard,  standard  money,  which  finally  determines  the 
value  of  that  money,  just  as  that  standard  money  determines  the 
value  of  the  money  unit.  Now,  it  can  hardly  be  doubted  that  the 
gold  or  silver  or  wheat  or  list  of  goods  used  in  our  illustrations 
answers  to  this  definition  of  the  ultimate  standard.  First,  by  hypoth- 
esis, the  standard  money  is  kept  equal  to  such  gold  or  silver  or 
wheat ;  and  so,  the  latter  is,  in  some  sense,  standard.  Secondly, 
since  this  gold  or  silver  or  wheat  is  not,  in  turn,  dependent  on  some- 
thing else  for  its  value,  such  gold  or  silver  or  wheat  constitutes  the 
final,  ultimate,  standard. 

Perhaps  a  doubt  may  still  linger  in  the  student's  mind.  "It  is 
plain  that  the  value  of  our  standard  money,  gold  coin,  and  the  value 
of  the  gold  metal  in  that  coin  are  equal.  But  are  we  sure  that  the 
value  of  the  metal  fixes  the  value  of  the  coin  rather  than  the  reverse? 
Surely,  gold  as  a  metal  has  its  value  influenced  by  the  value  of  the 
gold  money."  The  last  statement  is  no  doubt  correct:  the  value 


402  PRINCIPLES  OF  ECONOMICS  [XXXII 

of  money  influences  that  of  the  metal  just  as  truly  as  the  value  of 
the  metal  influences  that  of  the  money.  Nevertheless,  one  of  these, 
the  metal,  must  be  looked  on  as,  in  the  more  ultimate  sense,  a  de- 
terminant. The  gold  coin  of  any  one  country  constitutes  only  a 
small  fraction  of  the  total  gold  coin  of  the  world,  and  a  still  smaller 
fraction  of  the  total  gold  metal — coin,  articles  made  of  gold  and 
gold  bullion.  Conditions  tending  to  bring  about  a  change  in  the 
money  of  a  particular  country  independently  of  the  gold  stock  of 
the  world  must,  of  course,  tend  to  exercise  some  influence  on  the 
value  of  that  gold  stock.  But,  after  all,  the  small  fraction  cannot 
be  credited  with  determining  the  value  of  the  whole.  The  total 
gold  stock  must  have  a  value  resulting  from  the  action  of  number- 
less other  forces  as  well  as  the  causes  which  influence  the  value  of 
the  money  of  a  single  country;  and,  to  the  value  of  the  total  gold 
stock  as  thus  determined,  the  value  of  the  gold  coin  of  any  par- 
ticular country  must  tend  to  gravitate.  As  long  as  the  money  unit 
of  a  country  is  kept  equal  in  value  to  a  certain  quantity  of  the  metal 
gold,  that  metal  must  be  recognized  as  the  truly  ultimate  standard. 

ILLUSTRATIVE  PROBLEMS 

1.  A  few  years  ago,  the  United  States  remodeled  the  monetary  sys- 
tem of  the  Philippines,  making  silver  pesos  coined  only  for  the  govern- 
ment the  standard  money,  but  providing  that  gold  exchange  on  New 
York  should  be  sold  to  any  person  wanting  it  in  exchange  for  silver 
pesos  at  a  rate  of  $i  for  two  pesos.     Such  a  system  tended  to  establish 
what  ultimate  money  standard  in  the  Philippines? 

2.  Great  Britain  puts  into  every  sovereign  113  grains  of  pure  gold, 
coins  these  sovereigns  for  everyone  free  of  charge,  and  does  not  attempt 
to  hinder  the  melting  of  coins.     Under  these  conditions  what  necessarily 
becomes  the  ultimate  standard  of  Great  Britain?    Explain  fully. 

3.  What  must  have  been  the  ultimate  standard  of  the  United  States 
in  1830?     See  Problem  i,  page  399. 

4.  What  must  have  been  the  ultimate  standard  of  France  at  the  same 
date?     See  Problem  2,  same  page. 

Our  second  principle  with  respect  to  the  ultimate  standard  has 
to  do  with  a  situation  where  the  standard  money  is  itself  the  ultimate 


XXXII]  THE  MONEY  STANDARD  403 

standard.  Prior  to  1893  British  India  had  as  its  ultimate  money 
standard  180  grains  of  silver;  that  is,  the  unit  coin,  the  rupee, 
contained  180  grains  of  silver  and  was  freely  coined,  thus  making 
the  metal  itself  the  ultimate  determinant  of  the  value  of  the  rupee. 
But,  in  the  year  named,  the  government  stopped  the  free  coinage 
of  silver  with  the  result  that  coins  rose  in  value  as  compared  with 
the  metal  in  them,  fluctuating  from  32  cents  down  towards,  but 
never  to,  their  bullion  value,  22  cents.  Thus  the  silver  rupee  had 
nothing  behind  it  to  fix  its  value — it  moved  up  and  down  inde- 
pendently of  anything  else.  Accordingly,  the  silver  rupee  fixed 
the  value  of  the  unit  (the  rupee)  not  only  immediately  but  also 
ultimately;  and  hence  was  itself  the  ultimate  standard.  This  illustra- 
tion alone  would  seem  to  furnish  sufficient  proof  of  the  following 
principle : 

Principle  IV.  //  the  standard  money  is  not  kept  con- 
stantly equal  in  value  to  a  fixed  quantity  of  some  commodity 
or  group  of  commodities  outside  itself,  but  varies  in  value 
independently  of  the  variations  of  any  other  object,  then 
such  standard  money  is  itself  the  ultimate  standard  of  the 
system. 

ILLUSTRATIVE  PROBLEMS 

1.  What  was  the  ultimate  standard  of  the  United  States  between 
1862  and  1879?     Explain. 

2.  What  was  the  ultimate  standard  of  the  United  States  during  the 
panic  weeks  of  1837?    See  Problem  2,  page  396. 

3.  Suppose  that  after  1893  the  government  of  British  India  had  so 
managed  things  as  to  keep  gold  exchange  on  London  constantly  at  20 
rupees  for  i  sovereign  (123.27  grains  of  gold).     What  would  then  have 
been  practically  the  ultimate  standard  of  India? 


CHAPTER  XXXIII 

PRINCIPLES  GOVERNING  THE  CIRCULATION  OF 

MONEY 

The  second  group  of  principles  under  our  present  subject  con- 
cern the  circulation  of  money — the  capacity  of  money  to  form  a 
part  of  the  monetary  stock,  the  active  medium  of  exchange.  Will 
a  particular  money  circulate  at  all?  What  kinds  of  money  have 
the  greater  capacity  for  circulating — the  greater  tenacity  in  circula- 
tion? To  what  part  of  the  circulation  is  a  particular  kind  of  money 
likely  to  gravitate  ?  Will  it  tend  to  be  used  in  the  ordinary  business 
of  exchanging  commodities  or  will  it  more  probably  lie  most  of  the 
time  in  the  banks,  serving  the  purpose  of  a  reserve  fund  ? 

These  and  other  related  questions  are  of  importance  because  a 
government  may  in  one  case  find  it  desirable  to  keep  a  particular 
money  in  circulation ;  or  in  another  case  to  drive  a  particular  money 
out  of  circulation;  or  in  still  another  to  keep  a  particular  kind  of 
money  down  to  a  small  stock,  though  not  driving  it  out  altogether ; 
or  again  to  segregate  a  particular  kind  of  money  in  some  special 
part  of  the  system.  A  government  may,  I  say,  at  some  time  desire 
to  do  any  of  these  things;  but  it  can  no  more  accomplish  its  desire 
by  merely  decreeing  such  a  result  than  it  can  bridge  a  river  by  that 
process.  The  circulation  of  money  is  ruled  by  natural  laws;  and 
a  government  can  accomplish  its  objects  in  that  field  only  by  estab- 
lishing such  conditions  that  the  natural  laws  which  rule  the  cir- 
culation will  automatically  work  out  the  results  desired.  It  is  of 
prime  importance,  therefore,  that  we  should  be  familiar  with  the 
more  influential  of  these  natural  laws. 

The  first  principle  which  we  shall  lay  down  runs  as  follows: 

Principle  I.     Under  modern  conditions,  the  full  and 
continuous  circulation  of  any  kind  of  money  in  almost  any 

404 


XXXIII]  THE  CIRCULATION  OF  MONEY  405 

country  of  high  commercial  development  requires  a  measure 
of  legal  authorisation  from  the  government  of  that  country. 

The  most  decisive  proof  of  this  principle  is  to  be  found  in  the 
fact  that,  in  all  but  very  exceptional  cases,  the  circulation  of  a 
money  is  limited  to  the  country  where  it  is  legally  authorized.  Even 
nations  lying  geographically  side  by  side,  closely  connected  in  in- 
dustry and  commerce  and  using  the  same  monetary  standard  and 
the  same  system  of  denominations, — even  such  nations  do  not  usually 
circulate  each  other's  money  save  along  the  border.  Thus,  despite 
the  proximity  and  the  intimate  relations  of  Canada  and  the  United 
States,  Canadian  money  has  no  currency  in  this  country  outside 
Detroit,  Buffalo,  and  a  few  other  similarly  situated  places. 

This  connection  between  the  circulation  of  a  money  and  its 
legal  authorization  by  the  home  government  is,  of  course,  no  mere 
accident.  From  early  times  governments  have  been  wont  to  issue 
the  money  of  their  respective  countries ;  so  that  now,  habit,  if  nothing 
more,  would  make  the  public  chary  of  accepting  any  medium  of 
exchange  not  authorized  by  government.  Further,  authorization 
by  a  government  creates  a  presumption  that  that  government  will 
make  some  effort  to  insure  the  goodness  of  the  money  authorized. 
Such  moneys,  therefore,  will  naturally  be  more  readily  accepted 
in  ordinary  transactions  than  money  which  has  nothing  but  private 
backing.  Again,  as  between  a  money  authorized  by  one's  own 
government  and  one  authorized  by  the  government  of  some  other 
country,  men  will  naturally  have  more  confidence  in  that  authorized 
by  their  own.  Finally,  the  government  itself  will  usually  discrim- 
inate against  foreign  moneys  in  certain  relations,  for  example,  in 
determining  what  shall  be  receivable  for  public  dues  or  what  shall 
be  a  legal  tender  for  debts.  This  public  discrimination  will  exercise 
more  or  less  compulsion  on  private  persons  to  take  a  similar  attitude. 

We  have  seen  that  the  power  of  a  money  to  circulate  usually 
depends  on  some  degree  of  governmental  recognition.  Our  next 
principle  puts  this  case  somewhat  more  strongly. 

Principle  II.      Under  modern  conditions,  the  power  of 
any  money  to  hold  its  place  in  the  circulation  in  the  fullest 


406  PRINCIPLES  OF  ECONOMICS  [XXX1I1 

sense  varies  as1  the  extent  to  which  it  is  given  power  to  do 
the  different  kinds  of  money  work. 

Thus,  a  money  which  will  not  be  accepted  by  the  government 
in  payment  of  taxes  or  which  cannot  be  used  as  bank  reserves  will 
have  less  tenacity  in  circulation  than  a  money  which  enjoys  these 
prerogatives.  In  part,  evidently,  the  capacity  of  a  money  to  circu- 
late depends  upon  the  willingness  of  people  to  accept  it  in  return 
for  commodities  and  services.  But  some  persons,  anyhow,  will  need 
to  use  a  part  of  the  money,  received  in  exchange  for  their  goods, 
for  the  purposes  indicated, — to  pay  taxes  and  maintain  reserves. 
They  will,  therefore,  hesitate  to  accept,  or  perhaps  absolutely  refuse 
to  accept,  money  which  cannot  be  ultilized  for  these  purposes. 
Further,  if  the  money  is  one  which  they  are  not  really  free  to  reject 
in  trade,  they  may  yet  be  free,  as  in  the  case  of  the  circulating  notes 
of  a  bank,  to  return  it  to  the  issuer,  getting  in  exchange  some  money 
which  possesses  the  prerogatives  lacking  in  the  one  in  question. 
This  course  they  are  likely  to  take,  and,  in  so  doing,  they  put  such 
money  out  of  circulation. 

An  obvious  inference  from  the  principle  is  that,  if  we  wish  to 
diminish  the  tenacity  in  circulation  of  any  money,  we  can  usually 
do  so  by  depriving  it  of  some  prerogative ; 2 — refusing  to  receive  it 
for  taxes,  forbidding  its  use  as  bank  reserves,  or  prohibiting  bankers 
who  receive  it  from  paying  it  out  over  the  counter. 

The  two  principles  just  set  forth  affirm  that  moneys  of  superior 
quality — those  having  recognition  by  the  government  and  possessing 
all  money  prerogatives — remain  more  persistently  in  circulation  than 
inferior  moneys.  We  have  now  to  remark  on  a  principle  which 
seems  almost  in  flat  contradiction  of  these.  It  affirms  that  inferior 
moneys  have  greater  power  in  circulation.  The  formula  "bad  money 
drives  out  good,"  commonly  known  as  Gresham's  Law,  is  the  one 
most  in  vogue.  As  thus  stated,  the  doctrine  was  always  inexact; 


1  Remember  that  in  Economics  "to  vary  directly  as"  means  only  to  vary 
in  the  same  direction,  not  proportionately,  and  "to  vary  inversely  as"  means 
only  to  vary  in  the  opposite  direction,  not  proportionately. 

1  This  must  be  qualified  by  a  consideration  of  the  principle  about  to  be 
commented  upon. 


XXXIII]  THE  CIRCULATION  OF  MONEY  407 

and,  however  stated,  it  is  now  true  to  a  much  smaller  degree  than 
in  earlier  times.  Perhaps  the  facts  are  fairly  well  covered  in  the 
following : 

Principle  III.  Moneys  which  are  inferior  in  respect  to 
exchange  or  substance  value  commonly  show  greater  tenacity 
in  circulation  than  those  which  are  superior  in  these  respects. 

The  truth  of  this  principle  has  been  amply  confirmed  in  mone- 
tary history,— in  fact,  the  principle  is  one  of  the  few  in  economic 
science  which  have  been  accepted  primarily  as  inductions  from  ex- 
perience. Its  explanation  is  easily  found  in  the  causes  at  work. 
The  chief  of  these  causes  is  the  fact  that,  in  the  circulation  proper — 
the  use  of  money  in  actual  exchange  transactions — the  superiority  or 
inferiority  of  different  kinds  of  moneys  shows  relatively  little; 
whereas  in  various  other  uses,  less  strictly  belonging  to  the  circula- 
tion proper,  or  even  quite  outside  the  field  of  money,  the  superiority 
or  inferiority  shows  relatively  much. 

Take  first  the  case  of  standard  metallic  money, — gold  coin  in 
our  system.  Coins  short  in  weight  have  no  difficulty  passing  in 
trade.  Only  a  careful  test  would  prove  that  they  are  actually  short ; 
and  this  test  few  people  in  the  hurry  of  business  care  to  make. 
Further,  most  people  assume  that,  even  if  a  coin  is  really  short, 
no  trouble  will  be  experienced  in  passing  it  on  to  someone  else. 
In  active  circulation,  then,  inferior  coins  serve  as  well  as  any.  But 
not  so  in  other  relations.  If  a  jeweler  wishes  to  melt  a  gold  coin 
to  get  the  metal  for  use  in  this  trade,  he  naturally  chooses  a  ten- 
dollar  piece  of  full  weight,  258  grains,  rather  than  one  weighing 
somewhat  less,  say,  240  grains.  The  same  is  of  course  true  of  the 
exchange  dealer  who  has  occasion  to  send  gold  abroad  in  covering 
his  drafts.  Again,  the  peculiar  position  of  the  banker  strengthens 
in  another  way  the  tendency  of  short-weight  coins  to  stay  in  circula- 
tion. Governments  and  other  institutions  to  which  the  banker  makes 
payments  will  discriminate  against  inferior  coins,  so  that,  to  save 
himself  a  loss,  he  must  refuse  to  receive  them  extept  at  a  discount. 
But  depositors,  in  turn,  anxious  to  escape  this  discount,  studiously 
avoid  presenting  such  coins  for  deposit, — instead,  keeping  them  for 


4o8  PRINCIPLES  OF  ECONOMICS  [XXXIII 

their  own  use  in  trade,  while  they  take  to  the  bank  full  weight  coin 
or  other  par  money. 

The  illustration  just  used  concerns  standard  metallic  moneys 
which  show  differences  in  substance  value  as  well  as  in  exchange 
value.  But  paper  moneys,  which  differ  in  exchange  value  only, 
submit  easily  to  the  same  principle.  Thus,  prior  to  1863,  the  bank 
notes  of  this  country  issued  by  all  sorts  of  institutions  and  under 
all  sorts  of  conditions,  circulated  at  different  values  measured  in 
standard  money,  some  worth  100  cents  on  the  dollar,  some  worth 
95,  some  92,  some  97.  Of  these  notes  the  best  ones  usually  showed 
less  capacity  to  hold  their  place  in  the  circulation  than  the  inferior 
ones.  Their  acceptability  in  ordinary  trade  was  not,  indeed,  as  good 
as  that  of  gold  coin  which  was  only  a  little  inferior  in  weight.  But, 
assisted  by  the  ignorance  of  people  in  general,  by  the  indisposition 
of  tradesmen  to  displease  customers  by  challenging  money  offered  for 
goods,  and  by  the  anxiety  of  workingmen  to  keep  their  jobs,  anyone 
who  held  such  money  could  easily  pass  it  on  at  a  value  greater  than 
that  recognized  by  banks  and  other  dealers  in  exchange. 

On  the  other  hand,  the  inferior  notes  were  received  at  banks 
and  public  institutions  only  at  a  full  discount.  Accordingly,  they 
were  not  taken  in  for  deposit,  but  were  sorted  out  for  use  in  trade, 
while  notes  of  the  better  grades  went  in.  Further,  the  institutions 
in  question,  desiring  to  make  room  for  their  own  notes,  and  to 
accumulate  only  moneys  which  would  be  useful  as  reserves,  made 
a  practice  of  sending  home  for  redemption  all  the  foreign  notes 
they  received;  hence,  the  fact  that  the  ones  they  received  were 
chiefly  the  better  ones,  resulted  directly  in  driving  these  better  ones 
out  of  circulation.  Thus,  there  were  at  work  not  only  forces  tend- 
ing to  choose  the  inferior  moneys  for  the  circulation  proper,  but 
also  forces  tending  positively  to  drive  the  superior  out. 

It  perhaps  ought  to  be  added  that  even  when  the  inferiority  or 
superiority  among  moneys  is  not  openly  recognized,  though  ad- 
mitted by  the  initiated,  the  inferior  is  likely  to  show  a  stronger 
hold  on  the  circulation.  Banking  institutions  being,  as  we  have 
seen,  in  a  position  to  discriminate  by  paying  over  the  counter  the 
less  desirable  forms  of  money  and  retaining  for  reserves  the  more 
desirable,  can  and  do  keep  the  former  in  more  active  circulation. 


XXXIII]  THE  CIRCULATION  OF  MONEY  4OOy 

The  points  made  in  the  foregoing  discussion  apply  in  large 
measure  to  all  kinds  of  money.  The  considerations  now  to  be 
brought  forward  concern  only  credit  money.  Credit  money,  for 
example,  a  bank  note,  is  simply  a  promise  of  the  issuer  to  pay  upon 
demand  a  stated  sum  of  standard  money  or  its  equivalent;  and 
such  money  is,  by  return  to  the  issuer,  retired  from  circulation. 
Accordingly,  the  degree  to  which  such  a  money  is  able  to  maintain 
its  hold  on  the  circulation  depends  on  the  strength  of  the  tendency 
to  send  it  home.  This  in  turn  depends  chiefly  on  two  conditions: 
(i)  the  strength  of  the  motive  for  returning  it,  and  (2)  the  ease 
with  which  the  operation  can  be  carried  out.  As  respects  the  first, 
if  a  bank  note  or  other  credit  money  is  qualified  to  perform  all  the 
functions  which  the  standard  money  that  it  calls  for  can  perform, 
there  will  be  little,  if  any,  reason  for  sending  it  home.  If,  however, 
it  is  not  receivable  for  public  dues  or  is  not  a  legal  tender  for 
ordinary  debts,  there  will  be  some  holders,  anyhow,  who  have  ample 
motive  for  sending  it  in  to  be  exchanged  for  money  more  adequate 
for  their  purposes. 

The  working  of  the  second  condition  on  which  depends  the 
strength  of  the  tendency  to  send  credit  money  home — the  ease  with 
which  the  operation  can  be  carried  out — may  be  seen  from  an 
imaginary  illustration.  If  a  noteholder  lives  in  Boston  while  the 
issuing  bank  is  located  in  Butte,  Montana,  and  the  noteholder  has 
no  way  of  securing  redemption  except  by  sending  the  note  from 
Boston  to  Butte  and  bringing  back  the  money  at  his  own  expense, 
there  will  probably  be  little  of  such  sending  undertaken.  In  such 
case,  even  though  the  note  is  not  usable  for  the  payment  of  taxes, 
the  holder  will  content  himself  with  retaining  it  for  use  in  ordinary 
business.  Thus,  such  notes  tend  to  continue  in  circulation  rather 
than  go  out  by  return  to  the  issuer.  They  have  tenacity  in  circula- 
tion just  because  there  is  difficulty  in  sending  them  home. 

Although  the  conclusion  just  reached  was  based  merely  on  a 
consideration  of  the  causes  at  work,  its  soundness  has  been  fully 
confirmed  in  the  history  of  bank  note  issues.  Thus,  in  the  United 
States  in  the  early  part  of  the  last  century,  when  the  provisions  for 
securing  the  "homing"  of  notes  were  quite  inadequate,  those  notes 
which  could  be  returned  only  at  considerable  trouble  and  expense 


4io  PRINCIPLES  OF  ECONOMICS  IXXXIII 

almost  completely  monopolized  the  circulation  as  against  notes  which 
could  easily  be  returned.  This  was  conspicuously  illustrated  in  the 
city  of  Boston  as  between  the  notes  of  outlying  towns  and  those 
of  Boston  itself, — the  latter  being  largely  driven  out  by  the  former. 
The  condition  was  remedied  by  providing  for  the  redemption  at 
par  in  Boston  of  the  outside  notes,  and  establishing  an  arrangement 
whereby  the  institution  which  performed  this  task  became  in  effect 
a  clearing-house  for  these  notes. 

Under  the  complicated  conditions  of  modern  business,  the  money 
stock  of  a  country  naturally  distributes  itself,  or  is  consciously 
distributed,  into  different  parts  called  funds,  each  of  which  has  a 
special  function.  Thus,  a  very  considerable  part  of  the  stock  is  used 
as  a  medium  of  exchange  in  ordinary  business.  A  second  large 
quantity  constitutes  the  reserves  of  the  banks,  especially  those  out- 
side of  New  York  City.  The  New  York  bank  reserves  constitute 
a  third  fund,  distinct  from  ordinary  bank  reserves  because,  for 
reasons  too  complicated  for  review  in  this  place,  the  general  bank- 
ing reserves  of  the  country  largely  rest  upon  it.  This  fund  also 
requires  differentiation  because  it  is  the  chief  source  from  which 
must  come  the  money  employed  in  the  settling  of  international 
balances.  Another  very  significant  fund  is  the  150  millions  of  gold 
reserved  by  law  in  the  Federal  Treasury  for  the  redemption  of 
treasury  notes.  Under  the  Federal  Reserve  system  adopted  a  few 
years  ago,  the  reserves  of  the  so-called  regional  banks  ought  perhaps 
to  be  treated  as  constituting  still  another  special  fund. 

Now,  it  is  a  matter  of  some  consequence  that  the  proper  sort 
of  money  and  that  sort  only  should  find  its  way  into  each  par- 
ticular fund;  and  the  government  takes  pains  so  to  manage  the 
issue  of  different  kinds  of  money  that,  as  far  as  possible,  proper 
distribution  will  be  automatically  effected.  The  result  is  largely 
brought  about  by  issuing  just  the  right  denominations  of  the  money 
which  is  meant  for  a  given  fund  and  for  the  appointed  uses  of  that 
fund. 

Thus,  if  it  is  desired  to  keep  a  certain  type  of  money  out  of 
banking  reserves,  especially  out  of  the  New  York  reserve,  this  is 
accomplished  by  putting  out  the  money  in  small  denominations.  The 


XXXIII]  THE  CIRCULATION  OF  MONEY  4II 

principle  which  furnishes  the  basis  for  such  a  policy  may  be  stated 
as  follows: 

Principle  IV.  In  the  distribution  of  the  monetary 
stock  of  a  country,  money  of  smaller  denominations  naturally 
gravitates  to  the  Circulation  Proper,  the  part  which  is  being 
used  directly  as  a  medium  of  exchange;  moneys  of  larger 
denominations  gravitate  to  the  Reserves,  the  funds  kept 
by  banks  and  other  institutions  to  meet  credit  obligations. 

This  principle  has  been  utilized  in  the  practical  management 
of  our  silver  certificates,  and  so  may  be  said  to  have  been  estab- 
lished inductively.  But  it  naturally  results  from  the  conditions  and 
forces  present.  There  is  comparatively  little  need  for  money  of 
large  denominations  in  ordinary  transactions,  since  persons  engaged 
in  those  transactions  usually  pay  by  means  of  checks.  If,  then,  we 
restrict  the  issue  of  any  kind  of  money  to  large  denominations,  we 
are  certain  to  keep  the  greater  part  of  it  out  of  the  ordinary  circula- 
tion. On  the  other  hand,  in  the  ordinary  transactions  of  the  market 
there  is  much  need  for  small  money,  whether  in  effecting  payments 
outright  or  in  making  change.  In  consequence,  we  can  easily  infer 
that  money  of  very  small  denominations  will  remain  in  ordinary 
circulation  and  will  stay  out  of  the  bank  reserves,  unless  it  is 
issued  in  greatly  excessive  amounts.  As  a  matter  of  fact,  experi- 
ence shows  that  it  is  extremely  difficult  to  satisfy  the  everyday 
need  for  money  of  small  denominations.  The  government  of  the 
United  States  has  been  obliged  over  and  over  again  to  expand  its 
issue  of  fractional  silver  and  of  small  bills  from  $i  to  $5. 

ILLUSTRATIVE  PROBLEMS 

1.  In  1849,  when  the  United  States  had  free  coinage  of  both  gold 
and  silver,  a  change  in  the  relative  values  of  the  two  metals  sent  silver 
coin  to  a  premium,  i.e.,  two  silver  half-dollars  were  worth  $1.02.     What 
naturally  happened  to  silver  coin? 

2.  During  the   Civil   War,   the   government   of  the   United   States 
thought  best  to  borrow  money  by   paying   soldiers,   contractors,   et  al., 
with  treasury  notes.     Yet  it  was  desirous  that  these  notes  should  not  be 


412  PRINCIPLES  OF  ECONOMICS  [XXXIII 

added  to  the  circulating  medium,  but  should  soon  get  into  the  hands  of 
people  who  would  lay  them  one  side  and  hold  them  till  they  were  due, 
— in  other  words,  treat  them  as  bonds.  The  Treasury  finally  hit  on  a 
pretty  good  plan  to  accomplish  this,  namely,  the  issuing  of  these  notes  to 
bear  interest,  that  interest  to  be  compounded  every  six  months  but  to 
be  paid  only  at  the  end  of  three  years.  How  would  this  plan  tend  to 
accomplish  the  end  sought? 

3.  In  1862,  when  gold  payment  on  treasury  notes  had  already  been 
suspended,  the  United  States  began  the  issue  of  legal  tender  notes.     In 
consequence  gold  went  to  a  premium,  soon  being  worth  $1.15  per  dollar. 
What  naturally  happened  to  it  ? 

4.  Experts  consider  it  very  desirable  that  the  bank  note  circulation 
should  be  elastic, — should  expand  readily  when  the  need  for  money  in- 
creases and  contract  promptly  when  the  need  diminishes.     Of  these  two 
phases  of  elasticity,  the  second  is  in  a  sense  the  more  important,  in  that 
it  really  provides  for  the  first.     In  order  to  secure  this  power  of  prompt 
contraction,  various  provisions  have  been  enacted  or  proposed:  (a)  Estab- 
lish a  good  many  redemption  agencies  at  convenient  points  throughout 
the  country;  (b)  prohibit  any  bank  from  paying  out  in  regular  business 
the  notes  of  another  bank  except  in  the  city  or  district  where  the  issuing 
bank  is  located;  (c)  prohibit  the  use  of  bank  notes  as  reserves  by  banks 
outside  the  system;  (d)  take  away  the  right  of  legal  tender  to  govern- 
ment; and  so  on. 

Explain  in  each  case  why  the  provision  set  forth  would  naturally  con- 
tribute to  the  contractility  of  the  note  circulation. 

5.  In  1894,  on  account  of  excessive  issue  of  silver  and  paper  money, 
as  also  on  account  of  the  marked  decline  in  business  activity,  the  United 
States  had  a  great  excess  of  circulating  medium.     This  fact  (combined, 
doubtless,  with  other  causes)  led  to  a  considerable  contraction  by  ex- 
port to  other  countries.     What  kind  of  money  must  have  gone? 

6.  In  1886,  Congress  provided  by  law  for  the  issue  of  silver  cer- 
tificates of  $i,  $2,  and  $5  denominations,  and  in  1900  decreed  that  90 
per  cent  of  the  total  amount  of  such  certificates  should  be  in  denomina- 
tions from  $10  down.    What  did  they  hope  to  accomplish  by  this  legisla- 
tion? 


CHAPTER  XXXIV 

PRINCIPLES  GOVERNING  THE  MOVEMENTS  AND 
DISTRIBUTION  OF  MONEY 

The  monetary  stock  of  any  country,  as  also  of  the  world,  is 
constantly  in  motion.  Scarcely  a  day  passes  without  the  shifting  of 
considerable  sums  of  actual  cash  between  different  districts  of  the 
same  country;  and  even  the  movements  between  nations,  though  by 
no  means  so  frequent,  are  in  the  aggregate  very  extensive. 

Interest  in  Money  Movements. — For  various  reasons  these 
movements  of  money  are  of  much  interest  and  significance,  both 
to  the  specialist  and  the  general  public.  First,  every  money  move- 
ment considered  by  itself  tends  to  change  the  distribution  of  the 
money  stock  among  different  districts  or  countries;  and,  if  for  any 
reason  the  movement  in  one  direction  is  long  enough  continued, 
it  may  cause  an  excessive  supply  at  one  point  and  a  deficient  supply 
at  other  points.  As  a  matter  of  fact,  this  result  is  much  less 
likely  to  occur  than  people  commonly  suppose,  and  even  if  it  did 
occur  it  would  probably  be  quite  harmless.  Occasionally,  however, 
there  may  be  changes  of  a  'really  undesirable  character ;  and  so  a 
knowledge  of  the  principles  governing  them  is  needed  as  a  basis 
for  a  corrective  policy.  Moreover,  it  will  be  decidedly  worth  our 
while  to  have  a  knowledge  of  even  the  harmless  changes  in  distribu- 
tion, lest,  in  thinking  them  pernicious,  we  should  suffer  needless 
anxiety  and  make  ill-advised  efforts  to  modify  them.  In  the  second 
place,  there  are  some  kinds  of  money  movements  which  indicate 
diseased  conditions  in  the  monetary  system,  and  a  knowledge  of  these 
movements  is  pretty  certain  to  prove  useful  when  we  are  trying 
to  locate  the  trouble.  We  shall,  therefore,  in  the  present  chapter, 
set  forth  the  natural  laws  regulating  movements  of  money  between 
different  countries  or  districts,  and  regulating  the  territorial  dis- 
tribution of  the  stock  of  money  which  results  from  these  movements. 


4i4  PRINCIPLES  OF  ECONOMICS  [XXXIV 

A  notable  fallacy  in  connection  with  the  subject  of  money  move- 
ments is  almost  constantly  and  everywhere  current.  It  assumes 
that  buying  any  goods  or  services  from  another  country  naturally 
means  losing  some  of  our  stock  of  money  to  that  country.  If  we 
give  up  the  production  of  some  commodity  for  which  we  show 
comparatively  little  fitness,  and  commence  buying  that  commodity 
from  our  neighbors,  people  at  once  condemn  the  trade  as  certain 
to  draw  away  a  portion  of  our  money.  They  may  even  fancy  that, 
if  we  allow  perfect  freedom  of  trade,  all  our  money  will  be  drained 
away. 

Trade  and  Money  Movements. — This  error  was  fully,  though 
indirectly  exposed,  under  the  Principle  of  Reciprocity,  so  a  briefer 
statement,  with  a  slightly  different  emphasis,  will  serve  in  the  present 
connection.  The  dealings  of  one  country  with  another,  or,  more 
exactly,  of  the  people  of  one  country  with  those  of  another,  do 
not  in  themselves  lead  to  net  money  movements.  Even  if  interna- 
tional dealings  were  commonly  effected  with  money  directly,  there 
would  be  few  or  no  net  movements,  assuming  that  we  have  in  mind 
intervals  of  at  least  a  few  months  in  length.  The  reason  is  plain. 
No  sensible  person  wants  money  for  the  money's  sake.  Our  neigh- 
bors are  anxious  to  get  money  by  selling  their  products,  not  because 
they  wish  to  keep  that  money,  but  because  they  wish  to  use  it  again 
to  buy  our  products.  This  fact  appears  clearly  enough  within  the 
limits  of  our  own  town;  and  in  no  essential  respect  does  the  trade 
within  a  town  differ  from  the  trade  between  it  and  other  towns, 
or  from  the  trade  between  the  country  as  a  whole  and  other  countries. 
Money  naturally  comes  back  as  surely  as  it  goes  away. 

Again,  under  the  credit  regime  which  actually  prevails  in  inter- 
local  trade,  no  considerable  movements  of  money  ever  take  place 
except  in  very  unusual  circumstances.  The  reciprocal  claims  and 
obligations  between  the  dealers  of  different  countries  which  grow 
out  of  their  trade  dealings  are  transformed  into  claims  and  obliga- 
tions between  the  bankers  or  exchange  dealers  of  those  cquntries ; 
and,  between  these  bankers,  money  itself  actually  flows  only  when 
their  reciprocal  claims  fail  to  balance.  Furthermore,  this  failure  to 
balance  must  be  of  appreciable  duration — a  few  weeks  at  least;  for 


XXXIV],  MOVEMENTS  AND  DISTRIBUTION  OF  MONEY  415 

usually  an  exchange  dealer  with  an  adverse  balance  will  as  a  first 
resort  borrow  from  his  correspondent,  sending  money  only  when  it 
becomes  evident  that  the  adverse  balance  will  not  be  turned  into  a 
favorable  one  for  a  long  time. 

Capital  Movements  and  Money  Movements. — What  we  have 
thus  shown  to  be  true  of  trade  relations,  we  can  also  show  to  be 
true  of  investment  transactions — the  lending  of  capital  by  the  people 
of  one  place  to  the  people  of  another  place.  Transfers  of  capital 
between  communities,  like  trade  payments,  primarily  take  the  form 
of  debts  between  the  bankers  of  the  different  communities.  A 
person  in  England  who  lends  money  to  an  American  railroad  by 
purchasing  its  bonds  does  not  send  over  money  to  that  railroad ;  his 
payment,  exactly  like  a  payment  for  wheat  or  cotton,  appears  as 
a  debt  created  against  some  London  house  and  in  favor  of  some 
New  York  house.  It  is  thus  plain  that,  at  the  outset  anyhow, 
such  a  shifting  of  capital  does  not  constitute  a  movement  of 
money. 

But,  someone  may  object,  would  it  not  necessarily  mean  a  move- 
ment in  the  end?  For  transactions  in  capital,  unlike  trade  trans- 
actions, are  almost  certainly  one-sided;  Europe  might  lend  much  to 
America  while  America  lent  little  to  Europe,  and  hence,  to  balance 
the  claims  against  them  which  have  grown  out  of  buying  American 
bonds,  the  European  houses  would  apparently  sooner  or  later  be 
compelled  to  send  money.  But  even  here  another  alternative  is 
possible.  While  America  holds  an  abundance  of  claims  on  Europe 
and  may  use  them  to  demand  money  if  she  likes,  she  probably  will 
not  do  so,  because  it  is  not  money  that  she  wants.  The  borrowing 
railroads  do  not  want  money,  but  rails,  cars  and  locomotives.  And 
either  they  will  buy  these  articles  abroad  with  the  borrowed  money, 
or  they  will  buy  abroad  some  other  articles  in  order  to  release 
American  capital  and  labor  which  can  produce  the  rails,  etc.,  at 
home;  in  either  case,  America  buys  from  Europe  more  goods  than 
usual.  Thus  the  debt  of  European  exchange  houses  to  American 
exchange  houses  arising  out  of  the  fact  that  Europe  is  lending  us 
capital,  is  likely  to  be  matched  with  a  debt  of  American  houses  to 
European  houses  arising  out  of  the  fact  that  Americans  have  bought 


416  PRINCIPLES  OF  ECONOMICS  [XXXIV 

from  Europe  more  goods  than  usual.     The  debts  are  accordingly 
cancelled  and  no  money  will  flow  either  way. 

Circumstances  Causing  Money  Movements, — We  thus  see 
that  neither  trade  nor  investment  transactions  necessarily  involve 
money  movements.  They  may,  however,  involve  such  movements, 
if  the  circumstances  happen  to  be  of  a  particular  character.  Con- 
fining our  attention  for  the  moment  to  trade  relations,  let  us 
examine  what  those  circumstances  are.  Any  fact  which  causes  the 
total  volume  of  goods  or  services  bought  by  any  community  from 
other  communities  to  remain  for  some  time  in  excess  of  its  sales 
to  those  other  communities,  will  tend  to  bring  about  a  net  move- 
ment of  money  from  the  community  whose  purchases  are  in  excess ; 
on  the  other  hand,  any  fact  making  the  sales  of  a  community 
exceed  its  purchases,  will  tend  to  bring  about  a  net  movement  of 
money  into  that  community.  The  argument  is  too  simple  to  need 
elaboration.  The  exchange  dealers  of  a  community  which  buys  more 
than  it  sells  will  for  a  shorter  or  longer  period  be  in  debt  to  the 
exchange  dealers  of  other  communities.  But  the  creditor  dealers  do 
not  like  to  wait  indefinitely  for  their  pay,  and  so,  if  there  is  no 
promise  of  an  early  turning  of  the  tide,  they  will  probably  order  the 
money  itself  delivered.  This  principle  is  illustrated  almost  every 
year  in  the  trade  between  America  and  Europe.  The  exports  of 
America,  being  largely  agricultural,  are  naturally  "bunched"  at  cer- 
tain seasons;  while  its  imports  from  Europe,  being  generally  manu- 
factured products,  are  distributed  more  uniformly  through  the  year. 
Consequently,  temporary  balances  against  Europe  are  almost  sure  to 
appear  in  the  fall  season  and  to  lead  to  movements  of  money  toward 
America. 

There  are  likewise  conditions  under  which  investment  transac- 
tions may  cause  money  movements.  An  exchange  balance  created 
against  a  lending  country  by  the  movement  of  capital  is,  as  we  have 
seen,  usually  offset  through  the  natural  readjustments  of  trade — 
the  expansion  of  imports  into  the  borrowing  country.  But  if  the 
movement  of  capital  from  country  to  country  is  very  large  and  rapid, 
the  growth  of  trade  may  not  be  rapid  enough,  for  an  extended 
period,  to  restore  the  balance.  In  this  event,  the  creditor  country, 


XXXIV]   MOVEMENTS  AND  DISTRIBUTION  OF  MONEY  417 

unwilling  to  lose  the  use  of  its  capital,  if  only  for  a  few  weeks, 
will  probably  order  the  gold  shipped. 

Bringing  the  essential  points  of  the  foregoing  discussion  into 
a  single  statement,  we  have  the  following  principle : 

Principle  I.  The  dealings  of  one  country  (commun- 
ity) with  other  countries  in  respect  to  goods  and  capital 
do  not  in  themselves  naturally  lead  to  net  movements  of 
money  either  to  or  from  said  country;  but,  if  circumstances 
are  such  as  to  maintain  a  balance  of  claims  for  or  against 
said  country  for  a  period  of  several  weeks,  a  net  movement 
of  money  to  or  from  that  country  is  probable. 

Based  upon  the  above  principle  are  five  corollaries,  each  of  which 
should,  with  only  the  briefest  statement,  explain  itself. 

Corollary  i.  Money  tends  to  flow  to  any  country 
(community)  where  the  rate  of  discount  is  exceptionally 
high,  and  vice  versa. 

If  the  rate  of  discount  in  any  country  or  community,  let  us  say 
New  York,  rises  to  a  point  two  or  three  per  cent  higher  than  in 
London  or  Paris,  bankers  having  connections  in  New  York  will 
hasten  to  avail  themselves  of  this  opportunity  to  make  exceptional 
profit  by  transferring  funds  to  New  York.  Naturally,  they  will 
so  far  as  possible  use  credit  for  this  purpose.  But,  if  the  high  rate 
persists  and  they  continue  to  send  funds,  they  will  soon  exhaust  the 
available  supply  of  credit  and,  thereafter,  will  send  money. 

Corollary  2.  Money  tends  to  flow  from  a  country 
where  the  stock  is  abnormally  large  as  indicated  by  the  state 
of  the  central  reserves. 

This  corollary  is  closely  related  to  the  last.  An  excessive  money 
stock  causes  a  fall  in  the  rate  of  discount,  which  brings  into  opera- 
tion Corollary  i.  In  extreme  cases,  an  excess  of  money  raises  the 
prices  of  commodities;  this  naturally  brings  about  an  expansion  of 
the  import  trade;  and  the  latter,  by  creating  a  balance  against  the 
country,  finally  causes  an  outflow  of  money. 


PRINCIPLES  QF  ECONOMICS  [XXXlV 

Corollary  3.  There  tends  to  be  a  continuous  net  flow 
of  money  from  a  country  which  is  a  producer  of  standard 
money  metal. 

Corollary  3  remarks  the  tendency  of  money  to  flow  from  a 
country  producing  standard  money  metal.  The  reason  for  an  out- 
flow of  this  kind  is  not  far  to  seek.  The  natural  and  easy  way  to 
market  standard  money  metal  is  to  take  it,  directly  or  indirectly, 
to  the  mint,  have  it  turned  into  money,  and  sell  it  as  money — that 
is,  spend  it  for  goods.  By  this  process  the  money  stock  of  a  gold- 
producing  country  is  constantly  being  augmented,  and  is  constantly 
becoming  excessive;  and  with  an  excess  of  money  there  come  into 
operation  the  influences  already  cited  under  Corollary  2.  This 
proposition  needs  emphasis  chiefly  because  it  shows  the  folly  of 
undue  anxiety  respecting  an  excess  of  gold  exports  from  a  nation 
producing  a  large  amount  of  gold.  We  should  expect,  as  a  matter 
of  course,  that  the  custom  house  reports  of  the  United  States  or 
Australia  would  show  them  exporting  more  gold  than  they  import. 
Gold  is  one  of  their  important  products  which  they  naturally  use 
to  buy  things  they  cannot  produce  so  easily,  just  as  they  use  wheat 
or  wool. 

Corollary  4.  Money  tends  to  How  from  any  country 
which  has  experienced  a  marked  decline  in  industrial  ac- 
tivity. 

When  business  slackens  there  is  less  money  work  to  be  done ;  this 
makes  the  existing  money  stock  excessive,  and  so  brings  into  opera- 
tion Corollary  2. 

Corollary  5.  //  a  full  weight  metallic  money  comes  to 
command  a  premium,  it  tends  to  be  exported  from  the  coun- 
try. 

Full  weight  metallic  money  which  comes  to  command  a  premium, 
is  certain  to  be  withdrawn  from  circulation  almost  completely ;  since 
it  will  seldom  be  accepted  in  exchange  at  as  high  a  premium  as  that 
given  on  the  bullion  market.  But,  being  withdrawn  from  circulation, 


XXXIVJ  MOVEMENTS  AND  DISTRIBUTION  OF  MONEY  419 

it  becomes  mere  bullion,  a  metal,  not  money.  Again,  changing  such 
a  quantity  of  money  into  bullion  inevitably  makes  the  stock  of  bullion 
altogether  excessive  for  the  uses  to  which  it  can  now  be  put.  In 
consequence,  the  value  of  the  bullion  in  the  home  market  is  lowered 
as  compared  with  its  value  in  other  markets ;  to  put  it  a  little  differ- 
ently, the  premium  which  the  bullion  bears  at  home  is  not  so  great 
as  the  difference  between  its  nominal  value  as  money  and  its  value 
in  other  countries.  It  will  therefore  be  exported  to  those  countries 
where  its  value  is  greater. 

Money  Drains  Self-Corrective. — The  discussion  of  Principle 
I  and  its  corollaries  must  by  this  time  have  made  it  clear  that  pur- 
chase abroad  does  not  necessarily  mean  a  loss  of  money  from  the 
purchasing  country.  But,  further,  if  we  look  more  deeply  into  this 
subject,  we  shall  find  that  money  drains,  when  they  do  occur,  can, 
in  all  but  a  few  special  circumstances,  safely  be  left  to  correction  by 
natural  causes. 

Removes  Its  Own  Cause. — First,  the  movement  may  be 
stopped  by  the  automatic  reversal  of  that  condition  which  is  neces- 
sary to  bring  it  about.  That  condition  is  a  high  rate  of  exchange, 
a  rate  on  London,  for  example,  of  $4.89;  for  obviously,  the  exchange 
dealer  could  not  afford  to  send  gold  unless  he  got  out  of  the  transac- 
tion the  value  of  a  sovereign  $4.866-)-  plus  the  cost  of  sending  it, 
about  three  and  one-half  cents.  But  such  a  high  rate  of  exchange 
will  naturally  set  up  an  unusually  strong  tendency  for  the  export  of 
goods.  If  I  am  selling  wheat  to  London,  when  claims  against  Lon- 
don— which  will  be  used  to  pay  for  my  wheat — are  selling  at  several 
cents  above  par,  my  trade  will  be  unusually  profitable.  I  will  there- 
fore be  eager  to  sell  as  much  as  possible ;  but  so  will  other  American 
exporters  be  eager  to  sell,  and,  competing  against  each  other,  we  will 
shade  our  prices ;  with  prices  lowered,  our  eagerness  to  sell  will  be 
met  with  eagerness  of  Londoners  to  buy, — so  that  our  export  of 
goods  will  increase  at  a  bound.  But  what,  now,  will  be  the  conse- 
quence of  the  increase  in  exports  due  to  the  high  price  of  exchange? 
Manifestly,  those  exports  will  put  Londoners  in  debt  to  us,  will 
increase  the  supply  of  claims,  or  exchange,  on  London.  But  when 


420  PRINCIPLES  OF  ECONOMICS  [XXXIV 

exchange  becomes  abundant,  its  price  will  inevitably  be  lowered. 
And,  finally,  since,  as  we  saw  at  the  outset,  a  high  rate  is  necessary 
if  gold  is  to  be  exported,  the  lowered  rate  will  tend  to  check  the  ex- 
port. To  put  the  whole  argument  in  a  sentence :  Gold  cannot  go  until 
exchange  reaches  a  very  high  rate;  but  a  high  rate  of  exchange 
simulates  exports;  the  increase  in  exports  presses  down  the  rate  of 
exchange ;  and  the  lowered  rate  of  exchange  stops  the  outflow  of  gold. 

Starts  into  Operation  Corrective  Processes. — Not  only  is  an 
outflow  of  money  stopped  by  the  automatic  reversal  of  the  condition 
which  makes  it  possible,  but,  further,  a  persistent  net  movement  of 
money  tends  to  be  stopped  or  even  reversed  by  the  action  of  condi- 
tions which  its  own  continuance  establishes.  Three  processes  may 
be  distinguished : 

First,  a  money  drain  from  any  country  makes  the  surplus  banking 
reserves  from  which  money  for  export  is  taken,  in  the  chief  commer- 
cial centers  (London,  New  York,  etc.)  relatively  small.  Depletion  of 
the  surplus  reserve  will  raise  the  rate  of  discount — interest  collected 
in  advance — on  short  time  loans ;  since  the  rate  on  this  kind  of  loan 
is  almost  entirely  dependent  on  the  size  of  the  surplus  reserve.  A 
high  rate  of  discount  thus  established  will  make  the  country  a  de- 
sirable market  for  lenders,  and  so  will  tend  to  draw  in  the  floating 
capital  of  other  countries. 

Ordinarily  this  process  is  adequate  to  stop  an  excessive  drain  of 
money;  but,  if  it  does  not  prove  so,  a  new  and  slightly  different 
series  of  reactions  follow  and  usually  effect  the  desired  result. 
When  the  central  banking  reserve  becomes  scanty,  the  inclination  of 
people  to  buy  or  hold  international  securities, — the  trade  in  which 
is  usually  based  on  borrowed  capital, — rapidly  diminishes.  With  a 
fall  in  demand,  the  price  of  securities  also  inevitably  falls.  But  a 
lower  price  for  securities  will  encourage  foreigners  to  buy  them,  thus 
giving  New  York  an  abundant  supply  of  exchange  on  Europe. 
.Finally,  since,  as  we  have  already  seen,  abundant  exchange  means  a 
low  rate  of  exchange,  the  condition  necessary  to  further  outflow — 
a  high  rate  of  exchange — is  thus  removed. 

There  is  yet  a  third  chain  of  causation  which  comes  into  operation 
probably  a  little  later  than  the  others.  The  same  high  rate  of  dis- 


XXXIV]  MOVEMENTS  AND  DISTRIBUTION  OF  MONEY  421 

count  which  causes  a  fall  in  securities,  if  long  enough  continued, 
leads  to  a  fall  in  the  prices  of  the  great  export  staples,  such  as  cotton 
and  wheat,  which  are  speculated  in  like  securities.  This  fall  in  price 
leads  to  increased  buying  by  foreigners,  which  makes  foreign  ex- 
change abundant,  thus  lowering  the  rate  of  exchange,  and  checking 
the  outflow  of  money.  Finally,  if  the  outflow  went  on  long  enough 
to  produce  a  scarcity  of  money  in  the  country  as  a  whole,  there 
would  result  a  general  fall  in  prices,  which  would  stimulate  foreign 
buying  all  along  the  line  until  the  direction  of  the  money  movement 
was  completely  reversed. 

The  foregoing  arguments  would  seem  to  establish  beyond  ques- 
tion the  following  principle : 

Principle  II.  Every  net  movement  of  money  tends  to 
be  stopped,  or  even  reversed,  by  the  automatic  reversal  of 
that  condition  "which  is  necessary  to  bring  it  about,  or  by  the 
action  of  conditions  which  its  own  continuance  sets  up. 

From  the  above  principle  it  is  only  one  step  to  the  following 
corollary : 

Corollary.  There  is  never  any  danger  that  an  outflow 
of  money  from  a  particular  country  will  go  on  till  tJiat  coun- 
try is  denuded  of  its  monetary  stock. 

Every  net  movement  of  money,  even  a  moderate  one,  tends  auto- 
matically to  bring  about  its  own  stoppage.  But,  obviously,  if  this  is 
true  of  every  net  movement,  it  would  prove  to  be  true  of  any  move- 
ment so  extensive  that  it  threatened  the  complete  exhaustion  of  the 
money  stock. 

Automatic  Distribution. —  Another  important  principle  regard- 
ing the  distribution  of  the  money  stock,  and  one  which  is  little  more 
than  a  corollary  from  the  last  may  be  stated  as  follows  : 

Principle  III.  Generally  speaking,  the  monetary  stock 
of  a  country,  or  group  of  countries  having  the  same  stand- 
ard, tends  to  distribute  itself  according  to  relative  need. 


422  PRINCIPLES  OF  ECONOMICS  [xxxiv 

If  the  need  of  any  particular  country,  as  compared  with  other 
countries,  is  less  completely  satisfied,  this  fact  alone  will  tend  to  start 
a  process  of  redistribution,  which  continues  till  the  several  needs  are 
satisfied  in  equal  measure.  The  explanation  of  this  process  has 
already  been  anticipated.  If  the  stock  of  money  in  one  country,  as 
compared  with  another,  is  small  relatively  to  the  money  work  to  be 
done,  this  fact  will  show  itself  in  deficient  bank  reserves,  and  such 
a  deficiency,  causing  the  rate  of  discount  to  rise,  will  bring  an  inflow 
of  money  for  investment.  A  high  rate  of  discount  will,  moreover, 
cause  the  prices  of  securities  and  of  the  great  staples  to  fall,  again 
resulting  in  an  inflow  of  money.  The  process  by  which  an  excess 
in  any  country  is  corrected  by  an  outflow  to  other  countries  is  simply 
the  reverse  of  those  described.  There  first  results  from  the  excess  an 
expansion  of  the  bank  reserves;  large  reserves  bring  down  the  rate 
of  discount,  making  investments  unprofitable;  and  this  will  cause 
capital — and,  in  time,  money — to  be  exported.  The  low  rate  of  dis- 
count will,  moreover,  occasion  a  rise  in  the  prices  of  securities  and 
the  great  staples ;  foreigners  will  then  begin  to  sell  freely  on  our 
markets,  thus  expanding  our  foreign  debt ;  and  a  large  foreign  debt, 
raising  the  price  of  exchange,  will  very  quickly  result  in  the  export 
of  money. 

The  above  argument  treats  of  movements  occurring  between 
highly  developed  commercial  nations  having  the  ordinary  economic 
relations.  As  between  small  communities  where  standard  money 
metal  is  produced, — for  example,  South  Africa  and  the  Klondike, 
on  the  one  hand,  and  the  rest  of  the  world,  on  the  other,  the  working 
of  things  is,  if  anything,  more  simple.  The  extraordinary  abundance 
of  money  (for  in  such  places  gold,  even  in  its  raw  form,  at  once 
becomes  money)  and  the  great  scarcity  of  all  other  goods,  make 
prices  excessively  high ;  as  a  result,  goods  flow  in  at  an  extraordinary 
rate ;  the  community  has  constantly  a  large  balance  of  indebtedness 
against  it ;  and  money  must  constantly  be  sent  out. 

Interference  Sometimes  Needed. — Up  to  this  point  our  dis- 
cussion has  placed  a  special  emphasis  upon  the  self-regulative  char- 
acter of  monetary  distribution.  If  taken  in  too  absolute  a  sense, 
this  might  lead  to  a  misunderstanding.  The  last  of  our  principles 


XXXIV]   MOVEMENTS  AND  DISTRIBUTION  OF  MONEY  423 

governing  the  movements  and  distribution  of  money  must,  there- 
fore, be  one  which  in  some  degree  qualifies  those  heretofore  laid 
down. 


Principle  IV.  While,  in  general,  the  proper  distribu- 
tion of  the  world's  monetary  stock  among  the  different 
nations  can  safely  be  left  to  the  working  of  automatic 
forces,  circumstances  may  arise  under  which  it  is  desirable 
Consciously  to  control  particular  movements  of  money,  in 
order  to  maintain  the  stability  of  the  system  of  credit. 

In  a  typical  monetary  system  of  our  day,  a  large  part  of  the  total 
monetary  stock  consists  of  representative  or  credit  money  and  bank 
credit.  Under  such  an  order,  the  foundation  of  standard  money 
is  vastly  more  important  than  any  other  constituent  of  the  circulating 
medium ;  it  is  not  mere  money ;  it  is  emphatically  the  basis  of  the 
whole  system.  This  is  particularly  true  of  that  portion  of  the  stock 
of  standard  money  which  we  call  the  ultimate  reserve,  the  reserve 
kept  by  a  great  central  bank  or,  as  in  the  United  States,  by  the 
government,  to  redeem  credit  money.  To  maintain  this  reserve  in 
adequate  volume  is  of  the  greatest  moment,  not  because  we  need  it 
as  a  medium  of  exchange,  but  because,  if  it  proves  inadequate,  the 
whole  system  will  fall  in  ruins. 

Accordingly,  it  is  natural  that  every  extensive  movement  of 
standard  money  should  be  jealously  watched  with  reference  to  its 
possible  bearing  on  the  ultimate  reserve  of  the  system.  When  that 
reserve  is  being  drawn  down,  it  is  not  enough  to  say  that,  in  the 
long  run,  an  excessive  drain  will  correct  itself.  We  cannot  afford  to 
wait  for  the  long  run, — serious  consequences  may  overtake  us  in  the 
meanwhile.  The  disappearance  of  the  ultimate  reserve  would  mean 
the  overthrow  of  the  standard  ;  and  even  the  beginning  of  a  depletion 
which  threatened  to  be  at  all  serious  would  excite  such  anxiety  in 
the  business  world  as  gravely  to  injure  industry  and  perhaps  precipi- 
tate a  panic.  A  nation  may,  for  example,  find  itself  experiencing 
the  specie  drain  incident  to  a  great  war,  a  drain  for  which  automatic 
regulation  will  not  furnish  a  sufficiently  strong  or  sufficiently  rapid 
check.  Or  there  may  be  a  drain  arising  from  the  action  of  unwise 


424  PRINCIPLES  OF  ECONOMICS  [XXXIV 

statutes  or  other  artificial  conditions,  which  at  the  very  best  cannot 
be  changed  for  a  long  time.  In  such  circumstances,  it  might  easily 
be  the  duty  of  the  government,  or  the  great  central  bank,  to  take 
active  and  vigorous  measures  to  check  an  outflow  of  standard 
money,1 

ILLUSTRATIVE  PROBLEMS 

1.  During  the  years   1853  to   1864,  inclusive,  when  France  had  a 
system  of  bimetallism  at  a  coinage  ratio  of  15.5  to  i,  while  the  market 
ratio  was  about  15.3  to  i,  the  French  circulation  absorbed  about  $680,- 
000,000  of  gold,  and  ejected  about  $345,000,000  of  silver.     Explain  these 
facts,  using  one  of  the  corollaries  of  Principle  I. 

2.  "Between  America  and  Europe  there  is  usually  a  net  movement  of 
money  toward  Europe  during  the  second  quarter  of  the  year,  toward 
America  near  the  end  of  the  third,  and  early  in  the  fourth,  quarter." 
Explain  why  you  would  expect  this  to  be  true. 

3.  "A  country  has  never  been  despoiled  of  its  money  by  the  working 
of  its  international  trade." — Gide's  Political  Economy,  page  120. 

Why  does  he  feel  so  sure  about  this  ? 

4.  A  New  York  wheat  broker  sells  50,000  bushels  of  wheat  to  a 
Liverpool  miller,  and  sells  against  it  a  sight  bill  of  exchange  for  the 
proceeds,  £8735  i6s.     The  wheat  cost  him  84  cents  per  bushel. 

(a)  With  exchange  on  London  at  $4.88,  what  would  his  profits  be? 

(b)  What  would  they  be  with  exchange  at  $4.84? 

(c)  What  does  this  have  to  do  with  money  movements?     Explain 
carefully. 

5.  "Between  New  York  city,  as  the  banking  center  of  the  United 
States,  and  the  country  at  large,  there  is  usually  a  great  money  movement 
outward  from  New  York  during  the  summer  and  early  fall,  and  an  in- 
ward movement  toward  New  York  during  the  late  fall  or  early  winter." 

Explain  why  you  would  expect  this  to  be  true. 


1  The  most  important  device  employed  for  this  purpose  consists  in  raising 
the  rate  of  discount,  and  thus  bringing  into  operation  Corollary  I  of 
Principle  I. 


CHAPTER  XXXV 

PRINCIPLES  GOVERNING  THE  VALUE  OF  MONEY 

Thus  far  in  our  discussion  of  money  we  have  treated  it  as  a 
thing  apart  from  the  general  field  of  economic  goods,  a  thing  pecu- 
liar, and  governed  by  laws  of  its  own.  Again,  in  our  chapters  on 
Price  (Chapters  XXIX-XXXI),  we  for  the  most  part  spoke  of  econo- 
mic goods  as  if  money,  the  thing  in  which  the  prices  of  those  goods 
is  expressed,  were  not  to  be  considered  as  one  of  them,  essentially 
the  same  in  kind  and  governed  by  the  same  laws.  But  these  impli- 
cations are  misleading.  Money  is  in  a  sense  an  economic  good,  just 
as  wheat  and  cotton  are  economic  goods,  and  the  time  has  now  come 
when  we  must  so  treat  of  it.  We  must  show  that  money,  the  thing 
in  which  the  values  or  prices  of  most  other  goods  are  expressed,  is 
itself  subject  to  the  laws  of  value  and  price. 

The  chief  defect  in  our  earlier  reasoning  lay  in  the  assumption 
that  money  was  constant  in  value.  This  assumption  was  encouraged 
by  our  emphasis  on  the  idea  that  the  money  unit  is  tied  to  a  certain 
definite  quantity  of  substance,  say  25.8  grains  of  gold,  just  as  a  gallon 
measure  is  tied  to  8.33  pounds  of  water.  But,  as  a  closer  examina- 
tion will  disclose,  any  such  view  is  decidedly  inaccurate. 

The  analogy  between  the  case  of  the  money  standard  and  that  of 
the  liquid-measure  standard  is  not  as  perfect  as  we  have  assumed. 
In  using  8.33  pounds  of  water  as  a  standard  of  liquid  measure,  we 
need  have  no  anxiety  that  the  bulk  of  the  water  itself  will  change, 
and  so  cause  that  of  our  unit  to  change ;  for  we  can  make  those  con- 
ditions which  would  modify  the  bulk  of  water — temperature  and 
atmospheric  pressure— absolutely  the  same  in  all  times  and  places. 

But  we  cannot  parallel  this  operation  with  gold  and  its  value. 
We  cannot  say  that  we  will  have  as  our  money  standard  the  value 
of  25.8  grains  of  gold  under  fust  the  same  conditions  as  prevailed 
when  it  was  finally  adopted  in  1873;  for  we  can  never  reproduce 

425 


426  PRINCIPLES  OF  ECONOMICS  [XXXV 

those  conditions.  All  we  can  do,  and  all  we  try  to  do,  is  to  keep  the 
value  of  one  dollar  equal,  at  any  particular  time,  to  the  value  of  25.8 
grains  of  gold  at  that  same  time.  In  doing  this,  we  anchor  the  value 
of  the  dollar  to  a  value  which  itself  changes,  and  so,  of  course,  the 
value  of  the  dollar  will  change.  Doubtless  our  policy  in  this  matter 
is,  on  the  whole,  wise;  for  the  value  of  gold  changes  very  slowly, 
perhaps  more  slowly  than  that  of  any  other  single  commodity,  and, 
anyhow,  we  ought  to  have  the  same  standard  as  the  rest  of  the 
world,  which  is  gold.  But,  whether  wise  or  not,  this  policy  anchors 
our  money  to  something  which  changes  in  value,  and  so  the  value 
of  our  money  changes,  instead  of  remaining  constant,  as  has  all 
along  been  assumed. 

Measuring  Money  Value  Changes. — But,  although  changes 
in  gold  and  money  value  do  occur,  it  is  not  so  easy  to  establish 
the  fact  of  change  or  to  measure  its  extent  as  the  student  might 
imagine.  Gold,  being  the  standard  of  all  great  commercial  nations, 
there  is  practically  no  market  where  its  value  is  expressed  in 
terms  of  anything  but  the  money  unit.  There  is,  therefore,  prac- 
tically no  place  where  the  apparent  value  of  gold  and  money 
alters  at  all.  In  the  United  States,  25.8  grains  of  gold  is  always 
worth  one  dollar  and,  conversely,  one  dollar  is  always  worth 
25.8  grains  of  gold.  Hence,  our  only  method  of  ascertaining  changes 
in  the  value  of  gold  and  money  is  to  study  the  movements  of  the 
prices  of  other  things.  If  gold,  and  so  money,  should  all  at  once 
greatly  rise  in  value,  their  own  price — in  terms  of  each  other — 
would  remain  constant,  but  that  of  goods  and  services  in  general 
would  fall.  Conversely,  a  sudden  fall  in  the  value  of  gold  and 
money  would  show  in  a  rise  of  the  prices  of  all  other  things.  It 
would  seem,  therefore,  that  we  need  only  ascertain  the  changes  in 
the  general  level  of  prices  to  know  the  changes  in  the  value  of 
money ;  and,  in  large  measure,  this  is  what  we  try  to  do. 

Absolute  and  Relative  Changes. — But  we  scarcely  begin  an 
application  of  this  formula  when  we  run  upon  difficulties  of  a  most 
serious  nature.  Changes  in  the  value  of  money  would  surely  express 
themselves  in  opposite  changes  in  the  level  of  prices.  But  the  level 


XXXV]  THE  VALUE  OF  MONEY  427 

of  prices  may  also  be  affected  by  a  sudden  collapse  of  business  de- 
mand or  a  great  fall  in  cost  of  production.  In  other  words,  a 
change  in  the  general  price  level  may  really  be,  not  a  change  in  the 
value  of  money,  but  a  change  in  the  value  of  goods.  Or,  to  use  a 
better  expression,  some  changes  in  the  general  level  of  prices  have 
their  origin  in  causes  affecting  goods  rather  than  money;  and,  if 
called  changes  in  the  value  of  money  at  all,  these  may  be  distin- 
guished as  relative  changes,  while  changes  in  the  price  level  due  to 
catises  acting  on  money  itself  would  be  called  absolute  changes. 
A  familiar  instance  of  a  relative  change  is  the  following: 
When,  after  a  period  of  industrial  stagnation,  business  begins  to 
pick  up,  and  people  regain  their  faith  in  the  future,  there  naturally 
takes  place  an  expansion  of  demand  for  goods  of  all  sorts,  and  in 
consequence  a  measurable  rise  in  prices,  starting  among  a  few  com- 
modities but  gradually  extending  until  it  covers,  if  not  the  whole 
field,  at  least  a  large  portion  of  it.  As  the  boom  advances,  this 
movement  becomes  more  and  more  pronounced.  Every  one,  believ- 
ing prices  will  go  higher,  is  eager  to  buy,  that  he  may  have  something 
to  sell  at  the  higher  prices;  and,  of  course,  his  eagerness  to  buy 
means  more  demand  and  so  contributes  to  the  very  price  advance 
which  he  expects.  This  self-propagating  movement  continues  until 
the  expansion  has  passed  all  reasonable  bounds,  when  suddenly  some 
accident  precipitates  a  general  collapse  of  the  boom, — pricks  the 
speculative  bubble.  At  once  all  are  eager  to  sell,  no  one  wanting  to 
buy ;  and  this  sudden  expansion  of  supply  and  contraction  of  demand 
causes  a  falling-off  of  prices,  more  rapid  probably  than  the  rise  has 
been.  These  changes  all  take  place,  not  because  anything  has  hap- 
pened to  money,  but  because  something  has  happened  to  people  or 
to  goods. 

Take  another  illustration.  If  throughout  a  period  of  some  length, 
say  between  1850  and  1890,  technical  methods  generally  undergo  a 
rapid  improvement  so  that  the  costs  of  producing  large  numbers  of 
commodities  are  much  reduced,  there  naturally  follows  a  decline 
in  the  prices  of  these  commodities  so  great  as  to  lower  markedly  the 
average,  or  general,  price  level.  But  such  a  lowering  of  the  general 
price  level  could  not  properly  be  conceived  as  a  real  or  absolute 
advance  in  money.  In  a  very  natural  sense  of  the  terms  it  is  not  a 


42g  PRINCIPLES  OF  ECONOMICS  [XXXV 

change  in  the  value  of  money  at  all,  but  rather  a  change  in  the  value 
of  goods. 

So  much  for  relative  changes.  In  a  study  of  money,  however, 
it  is  of  course  not  the  relative  changes,  but  the  absolute  changes 
which  are  really  germane.  Our  reference  to  changes  in  the  general 
price  level  have  been  made  merely  to  guard  against  the  danger  of 
confusing  them  with  genuine  changes  in  the  value  of  money.  We 
turn  now,  therefore,  to  the  real  task  of  our  present  chapter,  the 
analysis  of  these  genuine,  absolute  changes. 

Quantity  Theory. — The  principle  governing  the  value  of 
money  which  is  looked  on  by  the  majority  of  economists  as  most 
truly  fundamental  is  known  as  the  quantity  theory  or  principle. 

Principle  I.     The  value  of  money  in  any  country  tends 
to  vary  inversely  as  the  quantity  of  money  in  that  country. 

The  Proof. — The  argument  for  the  quantity  theory  runs  some- 
what as  follows :  If  the  quantity  of  money  increases,  people  in 
general  will  have  more  to  spend,  will,  therefore,  demand  more  goods. 
But,  if  people  demand  more  goods,  no  corresponding  increase  in  such 
goods  being  provided  for  in  the  hypothesis,  prices  in  general  are 
certain  to  rise.  Finally,  such  a  rise  in  general  prices  is  the  same 
thing  as  a  fall  in  the  value  of  money.  An  analogous  argument  shows 
that  a  diminution  in  the  quantity  of  money  must  tend  to  raise  its 
value.  Thus,  if  the  quantity  of  money  diminishes,  people  will  have 
less  money  to  spend,  will,  therefore,  demand  fewer  goods,  and  so 
prices  will  fall ;  that  is,  the  value  of  money  will  rise. 

Confirmed  in  Experience. — This  argument,  though  an  a  priori 
one,  has  at  times  been  strikingly  confirmed  in  experience.  Thus,  in 
a  community  which  contains  only  a  few  thousand  inhabitants  there 
may  occur  a  great  gold  discovery,  producing,  in  a  few  months,  bul- 
lion to  the  value  of  hundreds  of  thousands  of  dollars.  As  this  bullion 
can  be  almost  instantly  turned  into  money  or  its  equivalent  bank 
credit,  the  money  demand  for  all  sorts  of  goods  will  at  once  greatly 
expand.  In  the  output  of  goods,  on  the  contrary,  there  will  be  no 


XXXV]  THE  VALUE  OF  MONEY  429 

corresponding  increase.  Consequently,  the  prices  of  goods  in  gen- 
eral show  a  rapid  rise.  And,  since  this  rise  is  caused  by  the  increase 
of  money  or  its  cheapening  (in  cost)  or  both,  it  constitutes  a  real  or 
absolute  fall  in  the  value  of  money.  In  gold  producing  districts, 
such  as  California,  Australia,  and  the  Klondike,  the  new  gold  was 
generally  used  as  money  at  once,  in  its  bullion  form,  without  waiting 
for  coinage.  The  eager  spending  of  this  new  metal  to  buy  the 
necessaries  and  luxuries  which  the  hitherto  poor  miners  craved, 
naturally  led  to  a  swift  advance  of  almost  all  prices,  that  is,  a  swift 
fall  in  gold. 

Application  to  Groups  of  Countries. — The  application  of  the 
principle  in  a  small  community  is  thus  easily  shown;  but  does  it  apply 
as  well  to  an  entire  country,  or  to  a  whole  group  of  countries?  In 
such  a  country,  or  group  of  countries,  will  the  value  of  money  tend 
to  vary  inversely  as  the  total  quantity  of  money  f  The  a  priori  argu- 
ment is,  of  course,  still  valid.  An  addition  of  200  million  dollars' 
worth  of  gold  to  the  world's  stock  must  surely  tend  to  modify  the 
gold,  or  money,  demand  for  all  goods  other  than  gold,  and  so  to 
modify  the  value  of  gold  as  measured  in  those  goods.  The  new  gold, 
or  much  of  it,  will  be  coined  and  pass  into  the  monetary  stock  of 
the  world ;  this  will  mean  a  corresponding  enlargement  of  the  ulti- 
mate reserves  to  which  gold  money  is  mainly  relegated ;  and  this 
enlargement  in  turn  will  lead  to  an  expansion  of  bank  credit,  and  so 
of  general  purchasing  power.  As  a  result,  buyers  will  find  it  easier 
to  get  possession  of  purchasing  power.  If  they  are  already  disposed, 
on  other  grounds,  to  go  into  the  market  as  buyers  of  wheat,  cotton, 
machinery,  etc.,  the  increased  control  of  buying  power  will  increase 
the  demand  for  those  goods.  Finally,  the  increased  demand  will 
tend  to  raise  the  prices  of  those  goods  or,  in  other  words,  to  lower 
the  value  of  gold. 

Nevertheless,  in  a  large  country  or  in  a  group  of  countries  the 
complete  working  out  of  this  process  cannot  be  looked  for  with  any- 
thing like  the  same  degree  of  confidence  as  in  a  limited  district. 
That  the  value  of  money,  even  in  such  cases,  tends  to  vary  inversely 
as  money  quantity,  assuming  that  sufficient  emphasis  is  laid  upon 
"tends,"  would  seem  almost  indisputable.  The  norm  toward  which 


430  PRINCIPLES  OF  ECONOMICS  [XXXV 

the  actual  value  of  money  gravitates,  about  which  it  varies  under  the 
influence  of  more  temporary  causes,  is  in  large  measure  determined 
under  the  principle  noted.  Nevertheless,  this  doctrine  requires 
much  qualification.  Historical  and  statistical  studies  have  seriously 
undermined  it,  and  not  a  few  economists  have  been  tempted  to  reject 
it  altogether.  In  the  opinion  of  the  writer,  the  doctrine  contains  a 
basis  of  truth  which  is  of  prime  importance.  But  the  limitations  to 
which  it  is  subject  in  actual  experience  and  which  seem  at  times  to 
reduce  its  practical  significance  almost  to  nothing,  must  be  clearly 
understood. 

Limitations. — First,  so  far  as  gold,  the  standard  money,  is  con- 
cerned, the  quantity  in  existence  changes  relatively  so  little  in  a  year, 
or  even  in  a  long  series  of  years,  that,  however  true  the  theory  might 
be,  we  should  have  great  difficulty  in  establishing  a  satisfactory  proof 
of  it.  In  the  case  of  many  commodities,  as  for  example  wheat,  the 
output  of  a  year  constitutes  almost  the  entire  stock  for  that  year, 
and  a  doubling  of  the  output  means  almost  a  doubling  of  stock.  But 
not  so  with  gold.  Its  physical  imperishability,  its  very  high  specific 
value,  and  its  technical  treatment  as  money  make  it,  economically 
considered,  immortal.  It  is  almost  never  consumed  in  the  sense  of 
being  irrevocably  withdrawn  from  the  market.  The  untold  accumu- 
lations of  the  centuries  are  in  large  measure  available  to  meet  the 
needs  of  today.  In  consequence,  an  increase  or  decrease  in  the  out- 
put does  not  cause  anything  like  a  corresponding  increase  or  decrease 
in  the  stock. 

Another  limitation,  or  set  of  limitations,  upon  the  quantity  theory 
grows  out  of  the  fact  that  in  any  modern  monetary  system,  purchas- 
ing power,  stated  in  terms  of  money,  is  not  rigidly  fixed  by  the  quan- 
tity of  money,  but  is  almost  indefinitely  elastic.  The  whole  point  of 
the  theory,  as  we  have  seen,  lies  in  the  assumption  that  if  people 
have  more  money  they  will  demand  more  goods,  and  that  if  they 
have  less  money  they  will  demand  less  goods.  It  is  easy,  however,  to 
show  that  many  causes  interfere  with  the  prompt  and  effective 
working  out  of  this  process. 

First,  a  small  quantity  of  money,  frequently  turned  over,  will 
demand  as  much  goods  as  a  large  quantity  of  money  circulating 


XXXV]  THE  VALUE  OF  MONEY  431 

slowly.  Money  demands  goods  every  time  it  is  spent  or  offered  in 
exchange;  and  when  it  is  not  being  offered  in  exchange  it  is  not 
demanding  goods.  Hence,  as  the  saying  is,  the  nimble  sixpence  may 
do  the  work  of  the  slow  shilling.  In  a  word,  rapidity  of  circulation 
may  neutralize  any  tendency  to  a  rise  in  value  caused  by  scarcity  of 
money,  and  slowness  of  circulation  may  neutralize  any  tendency  to  a 
fall  in  value  caused  by  an  abundance  of  money. 

In  the  second  place,  under  modern  conditions  the  monetary 
stock  has  a  degree  of  elasticity  sufficiently  high  to  neutralize,  at 
least  temporarily,  changes  in  quantity.  Only  a  small  proportion 
of  the  actual  circulating  medium,  the  buying  power  in  money  form, 
consists  of  gold.  A  much  greater  part  consists  of  bank  notes, 
secured  by  small  reserves  of  gold,  and  the  issues  of  these  may  be 
expanded  or  contracted  almost  at  will. 

But  there  is  an  even  more  important  consideration.  The  general 
course  of  wholesale  prices  is  largely  determined  in  the  great  ex- 
changes where  wheat,  cotton,  iron,  petroleum,  and  so  on  are  dealt  in. 
Now,  the  exchange  medium  employed  at  these  markets  is  not  money 
in  the  narrow  sense,  but  rather  credit.  Cotton,  wheat,  and  iron  are 
paid  for  with  checks,  and  these  checks  practically  never  lead  to  a 
call  for  cash — the  transactions  are  carried  on  almost  entirely  with 
deposit  currency.  But  this  sort  of  circulating  medium  expands  or 
contracts  virtually  as  it  is  needed,  expands  or  contracts,  indeed,  with 
the  expansion  or  contraction  of  the  very  business  which  employs 
it.  Just  because  a  dealer  has  bought  50,000  bushels  of  wheat,  he  can 
induce  his  banker  to  manufacture  on  his  behalf  say  $30,000  in  credit 
money,  secured  by  that  wheat,  and  ready  to  be  used  in  buying  more 
wheat.  The  new  wheat,  in  turn,  can  be  made  the  basis  of  additional 
bank  credit,  which  again  can  be  used  in  buying  still  more  wheat. 

There  must  always  exist,  to  be  sure,  a  basis  of  real  money ;  every 
new  bank  loan  must  be  secured  by  a  certain  reserve  of  standard  coin 
or  metal;  but  the  possible  expansion  of  the  loan  is  several  times  as 
great  as  the  necessary  addition  to  the  reserve.  Hence  if  business 
prospects  look  favorable  both  to  the  would-be  borrower  and  the 
bank,  the  purchasing  medium  can  be  and  will  be  expanded  almost 
indefinitely,  with  only  the  slightest  dependence  on  the  stock  of  money 
existing  at  the  time.  On  the  other  hand,  if  prospects  are  not  favor- 


432  PRINCIPLES  OF  ECONOMICS  [XXXV 

able,  the  buying  medium,  deposit  currency,  will  not  expand,  no  mat- 
ter how  large  the  reserves  of  real  money.  Immediately  it  appears 
that  the  quantity  of  money  has  little  to  do  with  determining  the 
demand  for  goods. 

Nevertheless,  with  all  these  qualifications,  the  quantity  theory, 
as  a  statement  of  a  general  tendency,  remains  unshakable.  In  the 
long  run,  the  general  level  of  prices — the  value  of  money — must  be 
influenced  by  the  quantity  of  money,  particularly  the  quantity  of 
standard  money. 

Forces  Acting  through  Quantity  Principle. — If  the  value  of 
money  varies  inversely  as  the  quantity,  we  should  need  little  argu- 
ment to  establish  certain  facts  concerning  the  effect  upon  value  of 
various  forces  that  influence  the  quantity.  Since  the  output  of  money 
metal  increases  the  stock,  it  must  tend  to  diminish  the  value  of 
money.  Since  a  high  cost  of  production  tends  to  diminish  output, 
and  a  low  cost  of  production  to  increase  output,  then  the  one  must 
tend  to  raise  and  the  other  to  lower  value — although,  due  to  the 
highly  speculative  character  of  mining,  this  cause  does  not  operate 
with  anything  like  the  promptness  or  certainty  characteristic  of 
many  other  industries.  Finally,  since  the  increase  or  decrease  of 
money  metal  used  in  the  arts  must  effect  opposite  changes  in  the 
amount  of  such  metal  available  for  use  as  money,  they  necessarily 
tend  to  increase  or  decrease  the  value  of  money. 

The  facts  just  mentioned  may  all  be  briefly  stated  in  a  corollary  of 
Principle  I. 

Corollary.  The  value  of  money  tends  to  vary  inversely 
as  the  quantity  of  standard  money  available,  and  hence  to 
•vary  inversely  ats  the  output  of  metal,  directly  as  the  cost, 
and  directly  as  the  quantity  used  in  the  arts. 

Conscious  Adjustment  Changes. — While  the  quantity  prin- 
ciple is  the  basal  doctrine  for  money  value,  special  circumstances 
may  arise  in  which  one  or  two  other  principles  have  greater  influence. 
Thus,  the  value  of  the  substance  used  for  the  monetary  standard  may 
at  times  be  determined  quite  independently  of  the  quantity  of  money, 


XXXV]  THE  VALUE  OF  MONEY  433 

and  then  the  value  of  money  be  fixed  in  accordance  with  the  value 
of  this  ultimate  standard  substance.  Whenever  the  value  of  the 
ultimate  standard  changes,  as  measured  in  at  least  one  important 
commodity,  then  the  value  of  the  money  dependent  on  that  standard 
will  also  change.  Business  men  of  experience,  alert  and  shrewd, 
will  certainly  refuse  to  sell  goods  at  the  old  prices  for  money  which, 
as  measured  in  an  altered  ultimate  standard,  has  fallen  twenty  or 
thirty  per  cent.  And  if  they  proceed  to  raise  prices,  this  will  consti- 
tute a  change  in  the  value  of  money  by  adjustment  to  a  changed 
ultimate  standard. 

Suppose  the  standard  of  a  country  is  a  metal  which  has  the 
status  of  a  mere  commodity  in  some  great  world  market  where  the 
country  in  question  maintains  intimate  trade  relations.  Thus  before 
1893,  India  had  a  silver  standard.  At  that  time,  as  now,  silver  was 
in  London  and  other  European  centers  a  mere  commodity,  bought 
and  sold  like  cotton  or  wheat.  Naturally,  it  showed  many  fluctua- 
tions in  price;  and  every  marked  fluctuation  was  followed  by  an 
opposite  change  in  Indian  prices,  particularly  of  imported  goods. 
When  silver  fell,  Indian  prices  rose ;  when  silver  rose,  Indian  prices 
fell, — in  a  word,  the  value  of  Indian  money  was  readjusted  to  varia- 
tions in  the  world  price  of  silver.  This  result  was,  of  course,  the 
natural  one  to  expect.  If  silver  fell,  the  value  of  Indian  silver  rupees, 
as  measured  in  English  pence,  would  fall ;  it  would  take  more  of 
them  to  buy  the  goods  imported  from  Europe;  and  so  the  dealer 
would  have  to  recoup  himself  by  charging  more  for  the,  goods.  But, 
if  dealers  in  imported  goods  charged  more,  dealers  in  domestic  goods 
would  in  the  long  run  have  to  do  the  same,  or  else  suffer  a  loss. 
Finally,  if  dealers  in  general  charged  more  for  their  goods,  laborers 
would  presently  have  to  begin  charging  more  for  their  services.  A 
rise  in  prices  begun  in  the  import  trade  would  thus  eventually  be 
extended  throughout  all  business  relations.  And  this  is  merely  to 
say  that  the  value  of  the  rupee  was  being  adjusted  to  the  value  of 
silver. 

A  second  illustration :  Suppose  the  standard  money  consists  of 
irredeemable  notes.  Changes  in  the  value  of  this  money,  as  measured 
in  the  metal  which  was  formerly  standard,  can  be  followed  in  the 
market  price  of  that  metal.  Thus,  during  the  American  Civil  War, 


434  PRINCIPLES  OF  ECONOMICS  [XXXV 

gold  went  out  of  circulation  and  was  speculated  in  on  the  open  mar- 
ket just  as  cotton,  wheat,  and  copper  are  now.  Every  day,  every 
hour,  its  price,  measured  in  greenbacks,  the  standard  money  which 
had  displaced  it,  rose  or  fell.  But  this,  of  course,  is  the  same  as 
saying  that  the  value  of  greenbacks,  measured  in  gold,  moved  in  the 
opposite  direction, — fell  or  rose.  Naturally,  every  seller  of  goods 
would  note  these  changes  in  the  greenback,  since  it  was  the  measur- 
ing unit  of  the  value  of  the  goods  he  was  selling.  Naturally,  too,  he 
would  sooner  or  later  make  some  effort  to  guard  himself  against  loss 
from  the  fall  in  greenback  values.  Doubtless  he  would  not  try  to 
readjust  his  prices  to  every  change,  but  we  can  be  quite  sure  that 
great  declines,  especially  if  long  continued,  would  lead  to  a  remark- 
ing of  goods,  a  readjustment  of  prices  to  correspond  to  the  decline  in 
standard  money. 

As  a  formal  statement  of  the  points  here  illustrated,  we  have  the 
following : 

Principle  II.  Whenever  the  conditions  are  such  that  it 
is  possible  for  the  general  public  to  have  fairly  conclusive 
evidence  that  a  change  in  the  value  of  the  ultimate  standard, 
as  measured  in  at  least  one  important  commodity,  has  taken 
place,  there  will  almost  certainly  follow,  more  or  less  rap- 
idly, a  direct  readjustment  of  the  value  of  money  (and  so 
of  general  prices)  to  the  changed  ultimate  standard. 

Credit  Fluctuation  Changes. — A  third  principle  concerns  the 
value  of  irredeemable  paper  money  as  affected  by  political  or  com- 
mercial uncertainty.  Irredeemable  paper  money  is  merely  credit 
money  which  has  hitherto  been  redeemed  freely  on  demand  in  the 
standard  money,  but  on  which,  for  the  time  being,  redemption  has 
been  suspended.  The  type  we  have  in  mind  is  issued  by  the  public 
treasury  or  a  central  bank  closely  allied  to  the  treasury,  for  example, 
the  Bank  of  England.  When  payment  on  such  money  has  been 
suspended,  it  inevitably  becomes  the  standard  money  as  shown  on 
page  398.  Now,  in  normal  times,  when  no  public  crises  intervene,  the 
value  of  money  of  this  sort  may  remain  at  about  the  same  point  for 
months  or  even  years.  That  point  will  be  below  the  value  of  the 


XXXV]  THE  VALUE  OF  MONEY 


435 


standard  displaced,  but  not  necessarily  much  below,  depending  on  the 
quantity  out,  the  skill  with  which  it  is  managed,  etc.  But  if  any 
period  is  marked  by  uncertainty  in  public  and  commercial  affairs,  for 
example,  if  the  nation  is  engaged  in  a  war  characterized  by  greatly 
fluctuating  fortunes,  anxiety  will  naturally  spread  abroad  lest  the 
government  will  in  greater  or  less  degree  repudiate  its  obligations. 
This  failure  of  the  public  confidence  will  of  course  react  on  the 
value  of  the  notes  as  measured  in  the  old  standard,  causing  that 
value  to  show  extraordinary  fluctuations  even  within  the  limits  of  a 
single  day.1  But  this  will  not  be  the  end  of  the  matter.  As  brought 
out  in  discussing  Principle  II,  dealers  will  more  or  less  fully  adjust 
their  prices  to  the  larger  changes  in  the  value  of  the  irredeemable 
paper  as  measured  in  the  old  standard.  The  final  result,  then,  will 
be  that  the  value  of  such  money,  as  measured  in  goods  in  general,  will 
vary  in  a  rough  way  with  the  degree  of  the  public  confidence  in  the 
certainty  and  proximity  of  its  redemption.  The  following  statement 
will  formulate  the  conclusions  of  our  argument. 

Principle  III.  During  a  period  marked  by  much  un- 
certainty, either  political  or  commercial,  the  value  of  irre- 
deemable paper  money  is  chiefly  determined  by  public  con- 
fidence in  its  ultimate  redemption,  varying  directly  as  said 
public  confidence. 

MISCELLANEOUS  PROBLEMS  UNDER  MONEY 

1.  "I  can't  understand  what  people  mean  when  they  say  that  money 
has  risen  in  value  since  1873.     Money  is  by  common  consent  the  measure 
of  the  values  of  all  other  things ;  and  so  its  own  value  must  be  fixed, — 
cannot  rise  or  fall." — A  Gold  Advocate  in  1896. 

Explain  his  mistake. 

2.  Why  would  changes  in  the  total  quantity  of  money  in  the  United 
States  between  1862  and  1879  naturally  have  had  more  influence  on  its 
value  than  equal  changes  would  have  had  between  1850  and  1860? 


1  As   seen   in   opposite  changes  in  the   value  of   the  old   standard  metal, 
quoted  in  terms  of  the  irredeemable  note. 


436  PRINCIPLES  OF  ECONOMICS  [XXXV 

3.  Extract  from  a  speech  in  the  campaign  of  1896:     "If  any  man  in 
this  community  would  offer  to  buy  all  the  eggs  at  25  cents  a  dozen  and 
was  able  to  make  good  the  offer,  nobody  would  sell  eggs  for  less,  no 
matter  what  the  cost  of  production,  whether  one  cent  or  five  cents  a 
dozen.     So  with  silver.     Free  coinage  would  establish  the  market  price 
of  silver  at  $1.29,  and  nobody  would  sell  for  a  cent  less." 

There  is  doubtless  a  sense  in  which  the  italicized  claim  is  true  but 
this  is  not  the  sense  which  was  intended.  The  speaker  meant  that  silver 
would  rise  to  $1.29,  as  measured  in  the  present  dollar;  so  that  there  would 
be  no  repudiation  of  debts  in  adopting  the  free  coinage  of  silver. 

(a)  Show  that  such  a  claim  is  not  established  by  this  argument. 

(b)  In  what  sense  is  the  statement  true? 

4.  "We  have  altogether  too.  little  money  in  the  country  ($2,600,000) 
not  enough  to  pay  the  railway  debt  ($6,000,000),  or  even  the  debts  of 
banks  to  depositors,  let  alone  the  business  debts."     Explain  fallacy. 

5.  A  few  years  ago  Mexico  had  a  silver  standard.     If  at  that  time 
silver  had  risen  in  value,  would  the  Mexican  dollar  have  risen  in  value  ? 
Would  it  have  risen  in  price?    Would  the  price  of  silver  bullion  have 
risen? 

6.  In  1856  the  monetary  system  of  France  was  bimetallism  at  the 
ratio  of  15.5  to  i.     The  market  ratio  at  that  date  was  about  15.3  to  I. 
What  must  have  been  the  monetary  standard?     Prove. 

7.  In  the  panic  of  1893,  when  in  America  money  was  so  scarce  that 
business  men  and  bankers  had  to  resort  to  all  sorts  of  substitutes,  such 
as  due  bills,  New  York  drafts,  deposit  certificates,  etc.,  an  eminent  Amer- 
ican economist  said  in  substance :     "What  do  you  think  now  ?     Was  I 
not  right  in  contending  that  the  stock  of  money  is  altogether  insufficient?" 

Did  the  facts  establish  his  contention? 

8.  Argument  against  Bryan  in  the  campaign  of  1896:     "I  can  see 
how  free  coinage  is  going  to  increase  the  profits  of  the  mine  owners  by 
doubling  the  value  of  silver;  but  I  do  not  see  how  it  is  going  to  help  the 
rest  of  us." 

Explain  the  fallacy  in  the  words  italicized. 

9.  During  the  sixth  decade  of  the  XIX  Century  when  France  had 
bimetallism  at  a  ratio  of  15.5  to  i,  though  the  market  ratio  was  about" 
15.3  to  i,  dealers  to  their  surprise  every  now  and  then  received  silver 
five-franc  pieces  in  payment  for  goods.     Why  should  this  have  surprised 
them? 


XXXV]  THE  VALUE  OF  MONEY  437 

10.  "Unless  the  government  redeems  all  worn  coins  at  their  face 
value,  a  coinage  in  active  use  always  shows  a  strong  tendency  to  de- 
terioration." 

Explain  why  this  is  bound  to  be  true. 

11.  "I  object  to  our  buying  outside  anything  which  we  can  produce 
at  home;  for  this  means  just  so  much  money  lost  from  our  coin  circula- 
tion." 

Show  that  this  is  unsound 

12.  About  1850,  when  the  United  States  had  bimetallism  at  a  ratio 
of  16  to  i,  there  took  place  a  considerable  fall  in  the  silver  price  of  gold, 
so  that  the  silver  in  an  American  silver  dollar  was  worth  2  to  3  cents 
more  than  the  gold  in  a  gold  dollar.     In  consequence,  silver  coins  gen- 
erally went  out  of  circulation,  only  the  much  worn  ones  remaining. 

Explain  (a)  why  most  went  out  and  (b)  why  some  stayed. 

13.  What  is  meant  by  saying  that  our  mint  ratio  between  gold  and 
silver  was  I  to  15.98? 

14.  "New  York,    Dec.    n,    1903.     The   banks   gained   from  the  in- 
terior this  week  $2,042,906." — Newspaper. 

Was  this  normal  ? 

15.  "London,  Oct.  3.     One  hundred  and  fifty  thousand  pounds  sterl- 
ing gold  will  be  shipped  tomorrow  to  New  York."     Was  this  normal? 


CHAPTER  XXXVI 

THE  PRESENT  SYSTEM  OF  DISTRIBUTION 

The  Problem  of  Distribution. — In  our  very  first  attempt  to 
describe  the  nature  of  the  existing  economic  order,  we  emphasized 
the  point  that  that  order  is  one  in  which  men  cooperate  in  the  proc- 
esses through  which  they  seek  to  satisfy  their  wants, — to  make  a  liv- 
ing. That  cooperation  is,  indeed,  spontaneous,  its  working  out  auto- 
matic ;  nevertheless  it  is  very  real  and  covers  by  far  the  greater  part 
of  our  economic  activities.  Economically,  we  constitute  a  vast  or- 
ganic complex  into  which  the  individual  more  or  less  skilfully  fits 
himself,  and  from  which  he  more  or  less  successfully  makes  his 
living.  Since  we  thus  constitute  a  vast  organism,  it  is  natural  to 
conceive  the  product  income  of  us  all  as  a  totality,  a  social  income 
which  is  broken  up  into  the  individual  incomes  of  the  members  of 
society.  Thus  conceiving  the  income  of  us  all,  it  is  natural  to  in- 
quire :  What  are  the  processes  and  principles  under  the  operation  of 
which  the  amounts  of  these  individual  incomes  are  determined? 
This,  then,  is  the  chief  problem  suggested  by  the  term  Distribution 
as  the  economist  uses  it ;  and  we  must  now  devote  ourselves  to  its 
solution. 

The  above  account  of  the  nature  of  the  problem  which  distribu- 
tion, as  a  division  of  economic  science,  presents  to  us  should  make 
it  clear  that  that  problem  is  not  concerned  with  the  division  of  the 
product  of  a  given  factory  or  mine  or  farm  among  the  persons  who 
participate  in  the  operation  of  such  factory  or  mine  or  farm.  In- 
stead, our  problem  is  concerned  with  the  division  of  the  total  product 
of  the  u'hole  economic  group  in  which  is  found  that  factory  or  mine 
or  farm, — as  well  as  many  other  factories  and  mines  and  farms,  and 
also  many  other  industrial  concerns, — among  all  the  members  of  the 
group.  Our  problem  stated  in  the  former  way  is  not  a  legitimate  one, 

438 


XXXVI]  PRESENT  SYSTEM  OF  DISTRIBUTION  439 

for  it  implies  that  we  may  reasonably  think  of  the  sharing  of  the 
product  of  a  single  industrial  concern  as  being  determined  inde- 
pendently of  other  concerns  belonging  to  the  same  general  economic 
group, — a  notion  which  is  surely  quite  untenable.  If  we  insist  on 
using  the  word  "shares"  in  this  connection  at  all,  we  must  mean  by  it, 
in  the  case  of  all  participants  but  the  entrepreneur,  the  sum  or  sums 
of  money  which  are  paid  each  one  in  exchange  for  his  particular 
service.  But  this,  obviously,  is  determined  by  multiplying  the  price 
of  a  unit  of  such  service  by  the  number  of  units  rendered.  That  is, 
the  fundamental  determinant  of  the  share  of  each  is  a  price.  But 
it  surely  is  evident  by  this  time  that  prices  are  things  which  are  not 
fixed  within  the  relations  of  a  single  concern,  but  over  the  industrial 
field  as  a  whole.  What  the  chief  engineer  of  a  particular  factory  gets 
may  be  determined  in  almost  entire  independence  of  his  contribution 
in  that  factory:  from  the  standpoint  of  that  factory,  his  wages  may 
be  an  absolutely  fixed  quantum  which  the  concern  has  to  accept  from 
the  general  market,  and  in  accord  with  which  they  have  to  adjust 
their  conduct  of  the  business. 


The  Principal  Kinds  of  Income 

Looking  at  the  matter  in  a  very  general  way,  it  may  be  noted  that 
shares  in  the  general  social  income  may  be  either  ( i )  economic  or 
(2)  non-economic.  The  former  are  such  as  are  obtained  through 
economic  relations,  processes,  for  example,  wages  from  the  sale  of 
labor.  Non-economic  shares  are  any  outside  the  above,  for  example, 
shares  obtained  by  theft,  cheating,  governmental  corruption,  gift,  and 
so  on.  Some  incomes  can  with  more  or  less  reason  be  assigned  to 
either  class.  Thus,  many  of  the  great  incomes  obtained  in  America 
from  the  exploitation  of  natural  resources,  such  as  lumber,  copper, 
and  oil,  which  we  usually  classify  under  one  of  the  regular  economic 
shares — profits — may  also  be  conceived  as  in  a  sense  non-economic, 
in  that  they  often  have  their  origin  in  the  foolish  or  corrupt  munifi- 
cence of  government.  Naturally,  the  study  of  incomes  undertaken 
here  will  be  concerned  with  those  which  can  properly  be  called 
economic. 


440  PRINCIPLES  OF  ECONOMICS  [XXXVI 

The  chief  economic  incomes  or  economic  shares  in  the  social  in- 
come are  wages,  interest,  profits,  and  rent.  These  terms  need  little 
definition.  Wages  are  a  form  of  income  which  men  receive  in  return 
for  personal  services — labor.  Interest  is  the  capitalist's  remunera- 
tion for  "carrying"  the  reserves  of  the  community,  supplying  the 
service  of  waiting,  and  takes  its  purest  form  in  loans  where  risks 
are  practically  eliminated.  Profits,  on  the  other  hand,  are  the  re- 
muneration paid  especially  for  taking  the  risks  or,  better,  for  taking 
the  responsibility  of  ownership.  Rent  is  the  hire  paid  for  the  use  of 
unproducible  or  indestructible  elements  in  land. 

Again,  we  should  note  as  a  general  point  that  economic  incomes 
are  of  two  distinct  classes — personal  incomes  and  property  incomes. 
Personal  incomes,  which  men  receive  in  exchange  for  personal 
services,  may  in  practically  all  cases  be  brought  under  the  category 
of  wages,  though  in  ordinary  speech  remuneration  for  the  higher 
forms  of  personal  service  is  usually  called  salary.  Property  in- 
comes, those  which  men  receive  in  exchange  for  services  given  by 
the  property  they  own,  fall  into  three  classes,  rent,  interest,  and 
profits. 

Functional  Distribution. — The  above  account  of  what  we  have 
called  the  economic  shares  suggests  that  distribution  under  the  pres- 
ent order  is  primarily  a  functional  process.  Each  member  of  society 
receives  a  share  which  is  supposed  to  represent  the  effective  social 
importance  of  the  function  which  he  performs  directly  or  through 
some  factor  which  society  authorizes  him  to  own.  Such  a  system  of 
distribution  is  not  logically  necessary.  We  could  conceive  an  order 
in  which  shares  were  determined  independently  of  function,  for 
example,  one  in  which  all  shares  were  equal,  as  is  commonly  advo- 
cated for  communism.  On  such  a  plan,  it  would  still  be  necessary  to 
try  to  ascertain  the  effective  social  importance  of  each  function,  in 
order  to  have  the  information  needed  to  enable  us  wisely  to  utilize 
our  stock  of  the  various  primary  factors.  But  that  knowledge  would 
not  influence  the  community  in  distributing  the  social  income.  The 
present  order,  however,  makes  income  correspond  to  function.  This 
view  of  the  matter  explains  how  it  is  that  the  economist,  when  study- 
ing distribution,  seems  to  busy  himself  almost  entirely  with  what  is 


XXXVI]  PRESENT  SYSTEM  OF  DISTRIBUTION  44! 

often  called  "functional  distribution,"  the  allocation  of  the  social 
income  to  the  several  different  functions  which  had  to  be  performed 
in  order  to  produce  that  income. 

Personal  Distribution. — In  contrast  to  functional  distribution 
as  thus  described,  we  have  "personal  distribution,"  meaning  the  allo- 
cation of  shares  to  actual,  concrete  persons.  Manifestly,  these  two 
distributions  are  not  necessarily  identical ;  since  any  person  may  be 
in  receipt  of  more  than  one  functional  share.  Still  the  process  of  ex- 
plaining incomes  compounded  of  two  or  more  functional  shares 
offers  no  difficulty,  since  such  incomes  are  mere  aggregates  of  the 
functional  shares  entering  into  them.  Accordingly,  the  economist 
seldom  feels  called  on  to  go  much  beyond  mere  functional  distri- 
bution. 

ILLUSTRATIVE  PROBLEMS 

i.  Mr.  Crane  puts  $3,000  into  a  grocery  business  and  works  him- 
self in  the  store  from  morning  till  night.  His  net  return  from  the  busi- 
ness is  $1,500. 

Make  an  imaginary  distribution  of  this  income  into  the  several  eco- 
nomic shares  which  are  probably  involved. 

2.  My  friend  has  eight  houses  and  lots  in  Ann  Arbor  which  he  rents, 
getting  for  each,  let  us  say,  $360  a  year.     Try  to  break  up  this  sum  into 
the  different  elements  which  probably  enter  into  it. 

3.  At  a  certain  inland  resort  rowboats  are  let  at  $1.50  per  day. 
Enumerate  the  different  elements  entering  into  this  sum. 

4.  "Production  is,  so  to  speak,  a  synthesis ;  distribution,  an  analysis." 
Explain  what  seems  to  be  meant. 

II 

General  Character  of  the  Process  Determining  the  Regular 
Economic  Shares 

Distribution  an  Exchange  Process. — Generally  speaking,  the 
process  whereby  these  regular  economic  incomes  are  determined  is 
simply  the  price- determining  process,  which  we  have  discussed  at 
length.  The  correctness  of  this  statement  may  be  seen  from  a 
mere  preliminary  examination  of  the  economic  incomes  which  will 


442  PRINCIPLES  OF  ECONOMICS  [XXXVI 

show  that  the  source  of  each  is  in  reality  nothing  more  than  the 
price  of  something.  Thus  wages  of  all  sorts — whether  those  of  a 
mechanic  in  the  automobile  factory,  for  example,  or  those  of  a  sales- 
man, advertising  writer,  or  general  manager — are  nothing  but  the 
prices  of  labor  services  brought  by  the  laborer  to  market.  Interest 
also  is  plainly  a  price;  for,  as  we  have  conceived  it,  the  lender  makes 
a  sale  of  the  service  of  waiting.  Rent  is  the  price  paid  for  the  use 
of  land  unmodified,  or  modified  only  by  improvements  which  are 
indestructible.  The  case  of  profits,  though  on  the  surface  less  evi- 
dent, is  at  bottom  not  materially  different.  The  entrepreneur  sup- 
plies the  service  of  responsibility-taking.  From  the  very  nature  of 
this  service,  it  cannot  be  sold  directly;  but  it  is  virtually  sold,  in  that 
the  entrepreneur  unites  this  service  with  the  services  which  he  buys 
from  other  agents  in  the  productive  process,  and  sells  the  total  result- 
ant on  the  general  market.  Profits,  therefore,  are  in  effect  a  price 
received  for  a  service  supplied. 

Another  less  direct  but  not  unimportant  sense  in  which  incomes 
are  determined  through  exchange  processes  should  perhaps  be  men- 
tioned in  this  place.  The  immediate  income  which  most  of  us  receive 
is  of  course  an  income  of  money  or  its  equivalent.  But  to  realize  this 
income,  to  obtain  gratification  for  our  wants,  we  have  to  turn  the 
money  into  commodities  or  services — bread  to  eat,  clothes  to  wear, 
rides  on  the  train,  etc.  Now,  obviously,  the  amount  of  such  goods 
which  we  enjoy  must  depend  in  large  measure  on  the  money  prices 
of  those  goods.  But  this,  in  turn,  is  a  matter  of  exchange.  Hence 
the  amount  of  goods  we  can  enjoy — our  real  income — depends,  again, 
on  the  processes  of  exchange. 

But  we  need  not  be  content  with  saying  that  the  sources  of  the 
economic  incomes  are  the  prices  of  services,  economic  goods,  which 
the  income-receiver  sells,  and  that  those  incomes  are  determined, 
through  exchange  processes,  by  the  laws  of  price.  We  can  be  more 
specific.  We  can  affirm  that  the  particular  services  in  question,  the 
services  of  labor,  land,  capital,  and  responsibility-taking,  belong  to 
the  class  of  economic  goods  which  were  earlier  designated  primary 
factors  or  cost-goods.  A  primary  factor,  as  we  remember,  is  one 
behind  which  economic  analysis  cannot  reach,  which  can  be  traced 
to  no  more  ultimate  source ;  and  we  should  be  able  to  see  with  little 


XXXVI]  PRESENT  SYSTEM  OF  DISTRIBUTION  443 

effort  that  the  factors  under  discussion  answer  completely  to  this 
description. 

The  services  of  land  are  obviously  primary  factors,  for  they 
flow  without  man's  assistance  from  a  source  which  man  has  not 
made.  Labor  services  again,  for  which  wages  are  paid,  flow  from  an 
unproducible  source — labor  power.  For,  although  labor  power  is, 
literally  speaking,  produced  and  continually  reproduced  by  the  nat- 
ural propagation  of  the  human  species,  it  is  seldom,  except  under  a 
slave  regime,  brought  into  existence  primarily  for  market  purposes; 
it  occurs  only  as  an  incident  to  living  and  precedes  the  origination 
of  economic  motives ;  and  we  may  accordingly  look  upon  labor  as 
one  of  the  ultimate  things  in  our  analysis,  something  behind  which 
we  cannot  go.  An  equally  clear  case  can  be  made  out  for  waiting 
power  and  responsibility-taking.  These  factors  are  indeed  supplied 
by  men  on  their  own  free  choice,  and,  unlike  labor  power,  are  sup- 
plied from  preconceived  motives  of  an  economic  sort ;  but  they  are 
preceded  by  no  factors  of  a  strictly  economic  kind — in  reaching  them 
we  have  reached  a  point  beyond  which  economic  analysis  cannot 
penetrate. 

We  have  seen  that  the  services  of  labor,  land,  capital,  and  respon- 
sibility-taking are  primary  cost-goods.  In  consequence,  wages,  rent, 
interest,  and  profits,  being  the  prices  of  these  different  services,  are 
prices  of  primary  cost-goods.  Naturally,  then,  the  particular  law  of 
price  operative  in  determining  these  distributive  shares  is  the  one 
which  determines  the  prices  of  primary  cost -goods.  But  the  principle 
governing  the  prices  of  such  goods  has  already  been  brought  out 
in  Chapters  XXIX  and  XXX.  It  follows  that  the  principle  there 
set  forth  is  in  essence  the  principle  which  in  the  long  run  governs 
the  regular  economic  incomes,  wages,  rent,  interest,  and  profits. 
Formulated  as  a  principle  governing  distribution,  it  may  be  stated 
as  follows : 

Principle.  Every  economic  income  tends  to  approxi- 
mate that  quantity  of  goods  which  constitutes  an  expression 
of  the  marginal  significance  to  people  at  large  of  the  actual 
output — when  competition  is  free,  the  natural  output — of 
the  type  of  service  rendered  by  the  receiver  of  said  income, 


444  PRINCIPLES  OF  ECONOMICS  [XXXVI 

and  which  also,  in  the  case  of  free  competition,  constitutes 
an  expression  of  the  net  marginal  disutility  involved  in  fur- 
nishing said  type  of  service. 

Ill 
Explanatory  Comments 

(1)  The  principle  of  distribution  above  laid  down  is  manifestly 
a  compound  one,  in  that  it  asserts  the  coincidence  of  income  both 
with  the  marginal  significance  of  the  service  rendered,  and  the  mar- 
ginal disutility  of  rendering  it,  provided  there  is  such  a  disutility. 
The  full  title  of  the  principle,  therefore,  would  naturally  be  the  "sig- 
nificance-disutility principle."     It  is  possible,  however,  to  treat  the 
two  parts  as  separate  principles;  and  this  is  perhaps  desirable  at 
times,  because  the  first  is  accepted  by  some  economists  who  would 
demur  at  the  second. 

At  any  rate,  the  first  part  of  the  principle,  which  is  much  the 
more  important  and  oftener  the  subject  of  reference,  will  certainly 
require  a  separate  title  of  its  own.  We  shall  therefore  frequently 
allude  to  the  "significance  principle,"  which  affirms  that  the  price 
of  any  primary  factor  tends  to  be  such  as  will  express  its  mar- 
ginal significance ;  or,  in  other  words,  that  any  economic  income  tends 
to  be  such  as  will  express  the  marginal  significance  to  people  at  large 
of  the  service  rendered  by  the  primary  factor  in  question.  Another 
designation  occasionally  used  is  the  "service  value  principle,"  the 
principle  that  each  person  tends  to  get  an  income  which  represents 
the  value  of  his  service  or  contribution. 

(2)  Our  principle  affirms  that  every  economic  income  tends  to 
approximate  (not  equal)  that  quantity  of  goods  which  expresses  the 
marginal  significance  attaching  to  the  service  rendered.    If  the  mar- 
ginal significance  of  a  piece  of  land,  for  example,  is  $500,  the  rent 
paid  for  that  land  will  approximate  $500,  but  not  necessarily  equal  it. 
If  the  labor  of  carpenters  has  a  marginal  significance  of  $5.00  per 
day,  the  wages  of  this  class  of  workmen  will  tend  to  be  $5.00  per 
day,  but  not  necessarily  equal  to  that  figure.     The  reason  for  this 
statement  will  be  evident  on  a  moment's  consideration  of  the  prin- 
ciples of  price  as  already  presented. 


XXXVI]  PRESENT  SYSTEM  OF  DISTRIBUTION  445 

We  remember  that  there  are  four  limits  of  price  determination, 
the  marginal  demand  price  and  the  first  extra-marginal  supply  price, 
above;  and  the  marginal  supply  price  and  the  first  extra-marginal 
demand  price,  below.  Since  it  is  perfectly  possible  that  there  should 
be  a  considerable  interval  between  these  limiting  prices,  actual  price 
may  vary  over  a  considerable  range.  This  statement  manifestly 
applies  to  the  primary  factors  from  which  incomes  are  derived,  just 
as  much  as  to  other  economic  goods. 

(3)  The  principle  teaches  that  each  person  tends  to  get  an  in- 
come which  represents  the  marginal  significance  of  his  services.    A 
given  employer  might  be  willing  to  pay  $8  a  day  for  carpenter 
service.    But,  taking  employers  all  together,  those  who  are  least  de- 
sirous of  having  carpenter  work  done  find  the  service  is  worth  to 
them  only  $5.00  a  day.     Five  dollars,  in  other  words,  expresses  the 
marginal  significance  of  that  type  of  service.    The  employer  who  is 
willing  to  pay  $8  will  therefore  need  to  pay  no  more  than  $5.00 
per  day.     This  is,  of  course,  the  same  principle  that  applies  in  the 
purchase  of  bread,  meat,  coffee,  and  other  ordinary  commodities. 
Whether  ethically  right  or  wrong,  there  is  nothing  peculiar  about  it. 

(4)  In  the  second  part  of  our  principle,  it  was  said  that  every 
economic  income  tends  to  be  one  which  constitutes  an  expression  of 
the  net  marginal  disutility  of  furnishing  the  type  of  service.     The 
word  "net"  is  introduced  to  provide  for  the  following  feature.    The 
act  of  supplying  certain  services  may  involve  advantages  as  well  as 
disutilities;  university  teaching,  for  example,  gives  men  opportunity 
for  the  pursuit  of  scientific  investigation,  and  practicing  law  gives 
men  standing  in  the  opinion  of  their  fellows.     Now,  evidently,  in 
cases  of  this  sort,  the  reward  received  by  the  man  who  supplies  the 
service  does  not  need  to  be  large  enough  to  express  the  full  disutility 
of  his  task,  but  only  large  enough  to  express  that  disutility  minus  the 
incidental  advantages.    An  artist,  scientist,  or  missionary,  however 
great  his  labor,  may  find  such  pleasure  in  the  exercise  of  his  talents 
or  in  contemplating  the  result  he  hopes  to  achieve,  that  he  will  con- 
sider himself  well  paid  if  he  receives  only  the  barest  living. 


446  PRINCIPLES  OF  ECONOMICS  [XXXVI 

ILLUSTRATIVE  PROBLEMS 

1.  One  eminent  economist  heads  the  chapters  in  which  he  treats  Dis- 
tribution with  the  title  Exchange-Distribution.     Argue  that  such  a  head- 
ing is  legitimate. 

2.  "The  economist  commonly  concerns  himself  too  much  with  func- 
tional distribution,  neglecting  personal  distribution."     What  is  the  point 
of  this  distinction?     Argue  that  most  that  might  be  said  under  the  head- 
ing of  personal  distribution  is  too  evident  to  need  much  elaboration. 

3.  "Orthodox  economics  teaches  that  the   natural  laws   regulating 
distribution  assign  to  each  owner  of  a  factor  of  production  that  portion 
of  the  product  which  is  economically  necessary  to  evoke  and  maintain 
the  efficient  operation  of  his  factor,  and  nothing  more." 

Assuming  that  the  doctrine  taught  in  this  text  is  substantially  that 
of  orthodox  economics,  show  that  orthodox  economics  leaves  room  for  the 
notion  that  the  owner  of  a  given  factor  in  production  might  get  some- 
thing more  than  the  amount  "necessary  to  evoke  and  maintain  the  effi- 
cient operation  of  his  factor." 

4.  "This  contractor  will  lose  $50,000  if  his  building  is  not  completed 
September  i.     Bricklayers  are  worth  $50  a  day  to  him,  yet  he  can  get  all 
he  needs  for  $8  a  day.     How  can  you  say  that  each  of  us  tends  to  get 
an  income  which  expresses  the  marginal  significance  of  his  service?" 
Point  out  the  error. 


CHAPTER  XXXVII 

THE  GENERAL  PRINCIPLE  OF  DISTRIBUTION: 
COROLLARIES 

Not  Precisely  Realized. — In  affirming  the  existence  of  the 
general  principle  of  distribution  which  was  presented  in  the  pre- 
ceding chapter,  it  was  not  intended  to  claim  that  that  principle  is 
precisely  realized  in  the  phenomena  of  actual  life.  The  lack  of  such 
realization  appears  in  both  aspects  of  the  principle  but  is  especially 
notable  on  its  significance  side.  Few  contributors  to  production 
receive  sums  which  exactly  correspond  to  their  contributions.  Some 
get  much  more ;  a  far  larger  number  get  less.  But,  in  this  respect, 
the  significance  principle  is  not  materially  different  from  any  other 
economic  law.  Those  hypotheses  which  we  assume  as  the  starting 
point  of  all  economic  reasoning,  absence  of  force,  fraud,  favoritism, 
monopoly,  and  other  conditions  interfering  with  freedom  of  competi- 
tion and  contract — are  far  from  being  realized.  Further,  were  none 
of  these  manifestly  abnormal  elements  present,  we  should  still  have 
human  ignorance,  folly,  and  inertia,  to  hinder  any  precise  realization 
of  the  principle. 

Sufficiently  Realized  to  Be  Important. — But,  while  this  and 
all  other  principles  of  economic  science  are  nowhere  rigidly  opera- 
tive, economic  phenomena  do,  in  a  broad  way,  come  under  their  con- 
trol. This  statement  is  more  conspicuously  true  of  some  other  prin- 
ciples than  of  the  one  before  us,  but  it  applies  to  this  one  also.  Such 
being  the  case,  it  follows  that  our  significance  principle  should  not 
and  cannot  with  safety  be  ignored  in  affairs  of  the  practical  world. 
It  frequently  is  ignored,  as  we  know ;  for  not  a  few  well-meant  but 
ill-advised  reforms  run  directly  counter  to  it.  But  the  outcome  of 
such  reforms,  just  because  they  neglect  the  principle,  is  invariably  a 
partial  and  sometimes  a  complete  failure.  To  bring  out  the  connec- 

447 


448  PRINCIPLES  OF  ECONOMICS  [XXXVII 

tion  between  such  failures  and  our  principle,  we  will  set  down  a  few 
of  its  more  important  applications  in  the  shape  of  corollaries.  Most 
of  these  concern  the  significance  side  of  our  principle ;  but  the  last 
relates  to  its  disutility  aspect. 

Corollary  i.  Attempts  to  fix-  arbitrarily  the  amount  of 
any  economic  share  whether  by  governmental  or  private 
action  without  changing  the  demand  for,  or  the  supply  of, 
the  particular  type  of  service  involved  can  succeed  only 
within  the  narrowest  limits. 

Illustrations  of  such  attempts  are  found  in  the  Statute  of  Labor- 
ers (1351)  designed  to  keep  wages  at  the  old  level  in  spite  of  the 
diminution  of  laborers  through  the  black  death  and,  more  recently, 
in  minimum  wage  laws  and  usury  laws. 

All  these  measures,  we  should  note,  are  attempts  arbitrarily  to 
regulate  the  value  of  something  without  changing  demand  or  supply. 
It  is  at  times  possible  arbitrarily  to  change  prices,  but  only  on  condi- 
tion that  one  accepts  the  consequences  in  the  shape  of  changed  de- 
mand or  supply.  Thus,  a  monopolist  may  arbitrarily  raise  his  price, 
but  only  on  condition  that  he  reconciles  himself  to  smaller  sales.  So 
the  workmen  in  a  particular  trade,  if  very  strongly  organized,  may 
put  up  the  wages  of  their  trade,  but  at  the  same  time  they  must  be 
content  with  fewer  jobs.  So,  again,  if  government  insists  on  estab- 
lishing a  maximum  price  for  some  producible  service  below  the  cost 
of  supplying  that  service,  it  will  have  to  be  satisfied  with  seeing  the 
supply  of  the  service  fall  off.  If  in  any  particular  case  the  action 
taken  to  fix  prices  does  not  alter  demand  and  supply  conditions,  it 
can,  as  the  corollary  affirms,  seldom  succeed  at  all. 

The  corollary,  as  stated,  really  contains  two  elements :  ( I )  An 
admission  that  the  shares  can  be,  in  some  degree,  fixed  arbitrarily  by 
legislation,  and  (2)  a  claim  that  this  is  possible  only  within  very 
narrow  limits. 

Let  us  begin  with  the  first  point. 

Some  Fixing  of  Shares  Possible. — (i)  A  share  can  always  be 
arbitrarily  fixed  within  the  limits  set  by  the  significance  principle,  as 


XXXVII]  DISTRIBUTION:    COROLLARIES  449 

against  any  departure  to  a  point  outside  those  limits  caused  by  a 
failure  of  competition  or  the  intervention  of  illegitimate  elements. 
For  example,  rent  is  not  seldom  driven  above  marginal  significance 
because  of  the  ignorance  or  inertia  of  tenants;  and  government  can 
then,  without  colliding  with  regular  economic  forces,  bring  it  down 
to  the  proper  level.  (2)  It  is  probable  that  there  is  nearly  always 
some  leeway  between  the  marginal  significance  and  the  first  extra- 
marginal  one,  in  which  case,  our  principle  fixes,  not  the  precise 
amount  of  each  share,  but  only  the  limits  within  which  it  may  range. 
But  one  point  within  these  limits  will  reconcile  supply  and  demand 
as  well  as  another.  Hence,  within  these  limits,  legislation  can  arbi- 
trarily fix  on  one  particular  point  rather  than  another,  without  com- 
ing into  collision  with  regular  economic  forces.  For  example,  if 
wages  anywhere  from  $1.20  to  $1.40  would  reconcile  demand  and 
supply,  the  law  might  fix  them  at  $1.40,  and  not  contravene  our 
principle  at  all..  (3)  It  is  admitted  that  the  prices  of  labor  services 
or  capital  services  or  land  services  can  be  fixed  at  points  somewhat 
outside  the  limits  set  by  the  significance  principle  because  of  the 
inertia  or  weakness  of  buyers  or  sellers  of  those  services.  But  this 
being  true,  it  is  surely  reasonable  to  claim  that  government,  when 
public  policy  demands  it,  can  take  advantage  of  similar  weaknesses 
consciously  to  fix  prices  somewhat  outside  the  limits  set  by  our 
principle. 

Limits  of  Such  Fixing  Narrow. — Such  arbitrary  fixing  of  the 
economic  shares  is  possible  only  within  very  narrow  limits.  ( i)  Law 
cannot  long  compel  people  to  pay  for  anything  more, — anyhow  much 
more, — than  it  is  worth  to  them.  (2)  Law  cannot  long  hinder  peo- 
ple from  paying  for  anything  as  much, — anyhow  almost  as  much, — 
as  it  is  worth  to  the  marginal  buyer ;  for  this  is  the  only  way  to  insure 
that  buyers  at  or  within  the  margin  will  get  the  goods,  as  against 
buyers  outside  the  margin.  (3)  Law  cannot  long  compel  people  to 
furnish  anything  for  a  price  much  below  that  which  expresses  to 
them  the  disutility  incurred  in  furnishing  that  thing.  (4)  Law  can- 
not long  hinder  people  from  taking  a  price  for  their  service  sub- 
stantially as  low  as  that  one  which  expresses  the  disutility  incurred 
in  furnishing  said  service. 


45o  PRINCIPLES  OF  ECONOMICS  [XXXVII 

Corollary  2.  Broadly  speaking,  the  share  per  unit  of 
each  class  of  producing  agencies  varies  inversely  as  the  size 
of  that  class. 

Abundant  land  makes  rent  low;  abundant  capital  makes  interest 
low ;  abundant  labor  makes  wages  low.  This  obviously  results  from 
the  joint  action  of  our  significance  principle  and  the  law  of  dimin- 
ishing marginal  significance  (page  305).  Each  productive  agent 
tends  to  get  an  amount  which  expresses  the  significance  of  the  con- 
tribution made  by  the  marginal  member  of  his  class.  But,  since  the 
larger  his  class  the  smaller  will  be  the  significance  of  the  contribution 
made  by  the  marginal  member,  therefore  the  larger  his  class  the 
smaller  the  income  which  each  member  will  get. 

In  saying  this,  as  in  stating  any  other  scientific  principle,  we  of 
course  assume  continuity  of  conditions.  An  increase  in  the  volume 
of  any  factor  would  not  necessarily  lower  the  rate  of  return  if 
accompanied  by  the  introduction  of  new  opportunities  for  employ- 
ing that  factor. 

Corollary  3.  Broadly  speaking,  the  share  per  unit  of 
each  class  of  producing  agencies  varies  directly  as  the  size 
of  other  classes  which  cooperate  with  it. 

Increasing  the  size  of  one  class  of  producing  agencies  increases 
the  share  of  the  others.  For  example,  if  capital  increases  in  volume, 
not  only  does  the  rate  of  return  to  capital  tend  to  fall,  it  is  equally 
true  that  the  rate  of  return  to  labor  and  land  also  tends  to  rise. 
The  argument  should  be  easy  to  follow. 

(i)  According  to  the  last  corollary,  the  condition  supposed 
lowers  the  rate  of  return  to  the  changing  factor.  (2)  Since  the 
total  going  to  said  changing  factor  out  of  the  product  of  earlier  units 
of  the  combination  is  fixed  by  multiplying  the  number  of  units  into 
the  rate,  said  total  will  be  smaller  than  before.  (3)  In  consequence, 
the  portion  of  the  product  of  earlier  units  going  to  the  other  factors, 
being  that  product  minus  the  total  going  to  the  changing  factor,  w'll 
be  larger  than  before.  Take  a  simple  illustration :  Ignoring  capital, 
let  us  suppose  that  a  certain  piece  of  land  will  yield  to  one  man's 
labor  14  bushels  of  wheat;  to  the  labor  of  two  men,  20  bushels;  to 


XXXVII]  DISTRIBUTION:     COROLLARIES  45! 

that  of  three  men,  24  bushels.  When,  now,  laborers  are  so  few  that 
land  needs  to  be  worked  in  the  first  stage  only,  the  whole  product, 
14  bushels,  will  go  to  labor.  When  it  becomes  necessary  to  put  on 
a  second  man,  he  will  add  only  6  bushels,  therefore  will  get  only  6 
bushels,  and  the  first  man  also  will  get  only  6  bushels,  thus  giving  the 
landlord  20  minus  12  or  8  bushels  rent.  So  when  a  third  man  has 
to  go  on,  his  significance  and  so  his  share  will  be  represented  by  4 
bushels;  the  shares  of  laborers  I  and  2  will  fall  to  the  same  figure, 
and  the  total  of  the  landlord  will  become  24  minus  12,  or  12  bushels. 
Thus,  increasing  the  number  of  laborers  lowers  their  share  and 
raises  that  of  the  landlord. 

That  diminishing  the  size  of  one  class  diminishes  the  shares  of 
the  others,  may  be  shown  merely  by  reversing  the  preceding  argu- 
ments. 

Corollary  4.      Increase  of  population  in  itself  tends  to 
lower  all  shares  but  rent,  most  of  all  common  wages. 

This  is  really  a  sub-corollary  from  Corollaries  2  and  3.  An  in- 
crease in  population  means  normally  an  increase  in  the  size  of  all 
classes  of  producing  agencies  except  land.  Hence  an  increase  in 
population  would  normally  mean  a  diminution  in  the  shares  of  all 
classes  except  those  receiving  rent.  Further,  this  diminution  would 
fall  most  heavily  on  wages  for  the  reason  that  increase  in  population 
means  a  greater  increase  in  labor  power  than  in  capital,  that  is,  in  the 
power  to  wait  or  assume  the  responsibilities  of  production. 

In  opposition  to  the  teaching  of  this  last  corollary  it  is  sometimes 
argued  that  increase  in  population  does  not  lower  wages  for  the 
reason  that  each  person  brings  into  the  world  capacity  to  produce  as 
well  as  capacity  to  consume.  He  adds,  therefore,  to  the  supply  of 
goods  just  as  much  as  to  the  demand.  This  merely  shows  that  there 
is  not  ordinarily  any  danger  that  the  new  laborer  will  be  unable  to 
get  any  wages  at  all.  It  does  not  show  that  he  will  be  able  to  get  as 
high  wages  as  before.  Since  the  stock  of  natural  factors  in  pro- 
duction and  the  stock  of  capital  are  not  increased  by  the  incoming 
of  the  new  laborers,  therefore  the  marginal  significance  of  labor, 
and  with  it  the  wages  of  labor,  must  tend  to  be  lowered. 


452  PRINCIPLES  OF  ECONOMICS  [XXXVII 

Again,  it  is  sometimes  argued  that  increase  in  population,  in  that 
it  makes  a  larger  market  and  so  justifies  the  resort  to  extreme 
specialization,  large-scale  production,  etc.,  really  raises  marginal 
significance  rather  than  lowering  it,  and  so  raises  the  shares  going  to 
labor  and  capital.  This  is  doubtless  possible  but  not,  in  my  opinion, 
probable.  In  most  countries  population  has  long  since  reached  the 
size  which  would  justify  a  resort  to  the  most  efficient  methods.  If  a 
particular  community  is  failing  to  take  advantage  of  the  possibilities 
of  large-scale  production  because  markets  are  too  small  to  justify  a 
resort  to  that  method,  this  smallness  of  the  markets  is  probably  not 
due  to  lack  of  the  population  necessary  to  make  a  large  market,  but 
to  the  lack  of  those  facilities  for  transportation  and  communication 
in  general  which  are  necessary  to  coalesce  the  different  small  markets 
into  one  large  one. 

Corollary  5.  Any  cause  which  restricts  competition 
among  the  persons  who  supply  a  particular  type  of  service 
tends  to  increase  the  rate  of  income  received  by  the  said 
persons. 

It  is  of  course  a  fact  familiar  to  the  student  that  producers  in  all 
lines  are  disposed  to  adopt  measures  to  limit  competition,  each  in 
his  particular  line.  Monopoly  in  some  form  or  degree  is  a  condition 
of  things  which,  consciously  or  unconsciously,  almost  everyone  tries 
to  see  realized  in  his  special  field.  Perhaps  the  entrepreneurs  in 
some  industry,  for  example,  sugar  production,  form  a  trust,  thus 
establishing  a  combination  so  wide-reaching  as  to  approximate  mo- 
nopoly. Or  perhaps  the  men  engaged  in  building  houses  in  a  certain 
city  form  an  agreement  whereby  they  promise  not  to  compete  in  the 
fullest  sense  against  each  other.  Or  perhaps  the  painters  combine 
to  restrict  their  numbers  by  refusing  to  take  on  more  thnn  a  fixed 
number  of  apprentices  at  any  one  time.  Now,  it  is  doubtless  hoped 
in  each  of  these  cases  that  the  action  described  will  increase  the 
returns  of  the  persons  interested;  the  entrepreneurs  in  sugar,  and 
the  building  contractors  will  get  larger  profits,  and  the  workmen  in 
the  case  of  painting  will  get  larger  wages.  Further,  it  is  doubtless 
true  that  the  result  thus  hoped  for  is  largely  realized.  Such  re- 


XXXVII]  DISTRIBUTION:     COROLLARIES  453 

strictions  of  competition  do  usually  increase  the  incomes  of  the 
persons  interested.  The  reasons  are  plain.  Diminished  competition 
means  decreased  output,  therefore  higher  marginal  significance, 
therefore  higher  price,  for  the  service  rendered. 

The  principle,  as  stated,  says  "rate  of  income"  rather  than  simply 
"income"  in  order  to  provide  for  cases  where  restricting  of  output 
might  increase  the  return  per  unit  of  service  performed  but  not  per 
person.  Thus,  the  whole  body  of  laborers  might  unite  to  keep,  say, 
one-fifth  of  their  number  idle,  hoping  thereby  to  increase  the  total 
income  of  their  class,1  while  in  fact  they  might  thereby  lower  the 
total  though  increasing  the  rate — that  is,  the  income  per  unit  of 
service  or  effort. 

Corollary  6.  Any  cause  which  restricts  competition 
among  the  persons  who  supply  a  particular  sub-class  of 
services  tends  to  lower  the  incomes  of  the  persons  who  sup- 
ply related  sub-classes  of  services. 

As  we  have  seen,  it  is  very  common  to  try  to  limit  the  output  of 
one's  own  type  of  service  in  order  thereby  to  raise  the  price  of  it. 
It  is  less  common,  but  by  no  means  rare,  to  hear  persons  who  have 
inaugurated  this  policy  attempting  to  enlist  the  sympathy  and  sup- 
port of  others  as  if  the  public  in  general  or  producers  in  general, 
were  to  gain  by  it.  That  persons  sometimes  succeed  in  this  attempt 
does  not  alter  the  facts  of  the  case.  Their  position  is,  generally 
speaking,  quite  untenable.  We  may  sympathize  with  their  aims,  may 
even  be  glad  to  suffer  some  loss  in  helping  them  to  realize  those 
aims  ;  but  we  are  bound  to  experience  a  loss — the  policy  in  question  is 
against  the  immediate  economic  interests  of  all  but  the  person*  di- 
rectly concerned. 

The  explanation  of  this  fact,  in  so  far  as  it  concerns  related 
workers,  should  call  for  no  elaboration.  Restricting  competition 
within  any  sub-class  of  productive  agencies,  say  painting,  drives  the 
persons  shut  out  of  that  sub-class  into  related  sub-classes, — carpen- 
tering, masonry,  etc., — thereby  increasing  the  size  of  said  sub-classes. 

1  It  probably  can  be  shown  that  as  a  mere  matter  of  economic  theory 
this  is  a  possible  res.ult.  It  does  not,  however,  seem  of  sufficient  importance 
to  reward  the  effort. 


454  PRINCIPLES  OF  ECONOMICS  [XXXVII 

As  a  consequence,  under  the  working  of  Corollary  2,  the  share  per 
unit  of  those  classes  is  lowered. 

Corollary  7.  Broadly  speaking,  improvements  in 
method  through  discovery  and  invention  tend  more  espe- 
cially to  increase  interest  and  profits. 

Such  improvements,  by  increasing  opportunities  for  the  employ- 
ment of  waiting  and  risk-taking,  increase  the  marginal  significance 
of  those  factors,  and  so  fulfil  the  conditions  of  the  principle.  This 
is  not  to  say  that  improvements  in  method  bring  no  advantage  to 
laborers ;  but  any  advantage  the  laborer  gets  comes  indirectly  in 
lowered  prices  and  in  the  greater  quantity  of  goods  which  lower 
prices  enable  him  to  buy. 

As  already  noted,  the  disutility  part  of  our  principle  is  of  much 
less  importance  than  the  significance  part.  Still  it  is  not  altogether 
negligible  in  practical  affairs.  In  so  far  as  any  class  of  persons 
depend  for  their  income  on  supplying  some  primary  factor  which 
involves  a  disutility,  we  cannot  arbitrarily  cut  down  that  income 
without  more  or  less  interfering  with  the  supply  of  that  factor. 
This  is  the  old  story  of  killing  the  goose  that  lays  the  golden  egg. 
One  good  reason  for  not  interfering  with  the  freely  made  price  of  a 
primary  factor  and  the  income  derived  from  it  is  that  only  so  can 
we  be  sure  that  the  stock  of  said  factor  will  be  assigned  to  its 
proper  tasks.  But  if  the  factor  has  a  disutility  cost,  there  is  an- 
other reason  for  not  interfering  with  its  price  and  the  income  derived 
therefrom,  namely,  that,  by  pursuing  such  a  policy,  we  are  liable  to 
cut  down  the  stock  or  output  of  the  factor.  This  point  may  be 
formally  stated  in  the  following  corollary. 

Corollary  8.  //  the  primary  factor  from  which  an  in- 
come is  derived  has  a  disutility  cost,  all  artificial  attempts 
to  reduce  that  income  are  likely  to  reduce  the  supply  of  said 
primary  factor. 


XXXVII]  DISTRIBUTION:     COROLLARIES  455 

ILLUSTRATIVE  PROBLEMS 

1.  Suppose  that  at  a  certain  date,  competition  being  free  and  general 
conditions  normal,  the  rate  of  wages  for  ordinary  labor  is  $1.50  per  day; 
and  suppose,  further,  that,  under  these  conditions,  the  legislature  passes 
a  law  forbidding  anyone  to  pay  or  receive  wages  less  than  $5  per  day. 
Do  you  believe  that  this  would  result  in  giving  everyone  wages  of  $5 
per  day?     Why? 

2.  "The  logic  of  their  (the  orthodox  economists')  teaching,  has  been 
that  wages  which  were  determined  by  free  bargaining  between  capital 
and  labor  would  be  just  or  reasonable  wages." 

Point  out  wherein  the  above  is  incorrect,  or  at  least  inadequate,  as  a 
statement  of  the  real  teaching  of  the  economists. 

3.  Quite  soon  after  her  entrance  into  the  war,  Great  Britain  under- 
took to  raise  a  large  revenue  by  the  exceptionally  heavy  taxation  of  the 
industries  especially  connected  with  war,  that  is,  the  industries  engaged 
in  producing  guns,  ammunition,  etc.     What  argument  could  be  made 
against  that  policy? 


CHAPTER  XXXVIII 
RENT 

In  Chapter  XXXVI  we  presented  the  general  principle  under 
which  the  four  economic  shares  in  distribution  are  determined.  In 
this  and  the  three  chapters  following,  we  give  a  somewhat  more 
detailed  study  to  each  of  the  shares  taken  separately.  We  begin  with 
rent. 


The  Nature  of  Rent 

As  understood  by  the  general  public,  the  term  rent  commonly 
means  the  consideration  paid  for  the  use  of  any  tangible  object,  such 
as  a  house,  a  horse,  a  boat,  an  automobile,  or  a  piece  of  land.  Eco- 
nomic usage  is  much  narrower,  for  it  includes,  not  hire  in  general, 
but  only  the  hire  of  land.  It  does  not  include  even  the  hire  of  build- 
ings, fences,  or  other  removable  or  impermanent  improvements 
standing  on  the  land.  When  trying  to  be  very  precise,  indeed,  it 
speaks  of  rent  as  derived  from  the  original,  indestructible  elements 
only  of  land,  excluding  all  improvements  wrought  by  man.  even 
those  of  the  most  permanent  sort.  As  a  matter  of  fact,  this  usage  is 
not  perfectly  feasible  for  the  reason  that  some  improvements  are  so 
indestructible,  so  irremovable,  so  altogether  permanent,  that  they 
become  in  effect  inseparable  parts  of  the  natural  thing  itself.  Thus 
a  tile  ditch  laid  in  a  field  becomes  once  and  for  all  a  part  of  it ;  no 
one  will  ever  take  up  the  ditch,  no  one  will  need  to  give  it  more  than 
an  insignificant  amount  of  repairs,  and  it  will  last  indefinitely.  Like- 
wise the  increased  fertility  of  the  land  resulting  from  its  drainage 
is  a  quality  which,  though  originally  created  as  an  improvement,  can 
never  again  by  any  probability  be  extirpated,  so  long  as  the  land 
itself  endures.  In  consequence,  the  common  practice  is  to  interpret 

456 


XXXVIII]  RENT 


457 


economic  rent  as  paid,  not  only  for  unimproved  land,  but  also  for 
land  improved  in  the  ways  indicated. 

The  difficulty  which  is  usually  met  in  the  way  just  indicated,  is 
by  some  writers  met  by  refusing  to  distinguish  the  hire  of  land 
from  that  of  other  goods, — calling  them  all  rents  or  hires.  This 
practice  has  not  become  general,  and,  in  my  opinion,  is  of  doubtful 
expediency.  The  chief  reason  is  that,  in  connection  with  certain 
problems  of  value  determination  and  particularly  in  connection  with 
the  incidence  of  taxes,  strictly  non-producible  goods,  fixed-supply 
goods,  behave  in  a  quite  different  way  from  ordinary  producible 
goods,  and  improved  land  behaves  generally  like  the  strictly  non- 
producible  goods. 

II 

The  Origin  of  Agricultural  Rent 

Rent  Originates  Like  Any  Price. — Rent  is  a  price — the  price  of 
the  services  given  off  by  a  piece  of  land  during  a  given  period  of 
time.  It  follows  that  the  most  natural  way  to  explain  the  origin  of 
rent  is  that  which  is  used  in  explaining  other  similar  cases  of  price. 
Any  appropriable  thing  will  have  a  price,  provided  the  demand  for 
that  thing  at  some  price  above  zero  is  greater  than  the  available  sup- 
ply. Inadequacy  of  supply  to  equal  the  demand  at  any  price  above 
zero  is  sufficient  to  insure  the  existence  of  a  price.  Such  inadequacy 
doubtless  exists  in  the  case  of  land  services,  anyhow  in  the  ca.se  of 
services  of  lands  which  are  superior  in  respect  to  fertility  or  loca- 
tion. This  is  sufficient  to  give  such  services  a  price  and,  therefore, 
sufficient  to  explain  the  existence  of  rent. 

Special  Explanation:  Surplus  Theory. —  But,  while  the 
existence  of  rent  does  not  necessarily  call  for  any  explanation  other 
than  the  one  commonly  given  for  the  existence  of  price  in  other 
cases,  it  is  customary,  especially  in  the  case  of  agricultural  rent,  to 
set  forth  some  more  specific  and  elaborate  theory.  Such  theories 
are  not  to  be  conceived  as  inconsistent  with  the  explanation  of  rent 
just  given,  but  rather  as  explanations  which  go  back  a  little  further 
or  in  a  little  deeper, — explanations  which  attempt  to  show  the  process 
whereby  the  conditions  indicated  come  to  be  fulfilled.  The  particular 


458  PRINCIPLES  OF  ECONOMICS  [XXXVIII 

theory  which  most  commends  itself  to  the  present  writer  may  be 
called  the  surplus  theory. 

First  Hypothesis 

In  explaining  this  theory,  we  will  begin  with  the  hypothesis  that 
all  the  land  is  of  one  grade,  and  that  its  productive  capacity  is  abso- 
lutely fixed — with  just  the  right  expenditure  of  labor,  waiting,  etc., 
it  can  produce  a  certain  amount  of  product,  less  expenditure  will  pro- 
duce nothing,  more  expenditure  will  add  nothing.  Such  a  hypothesis 
is,  of  course,  in  the  highest  degree  unreal,  but  it  will  serve  best  in 
bringing  to  light  the  causation  process  through  which  rent  comes 
into  existence.  At  the  outset,  then,  we  take  the  small  isolated  island 
of  classical  convention.  That  island,  we  will  suppose,  contains  just 
1,000  acres  of  land  of  the  same  grade  of  fertility  and  the  same  de- 
gree of  accessibility ;  the  sole  agricultural  product  wanted  is  wheat,1 
each  acre  of  land  will  yield  to  the  proper  expenditure  just  20  bushels 
of  wheat,  no  more  and  no  less ;  and  the  cost  of  the  labor,  waiting, 
and  other  factors  necessary  to  produce  these  20  bushels — not  in- 
cluding, however,  the  services  of  land — is  $6  or  30  cents  per  bushel. 

Starting  from  this  hypothesis,  what  condition  or  conditions  will 
be  necessary  to  bring  rent  into  existence?  In  the  first  place,  it  is 
certain  that  this  result  cannot  be  reached,  rent  cannot  exist,  so  long 
as  the  demand  for  wheat  at  every  price  higher  than  50  cents — even 
one  of  only  31  cents — is  less  than  20,000  bushels.  The  best  way  to 
demonstrate  this,  perhaps,  is  to  make  the  contrary  supposition,  that, 
through  some  process  or  other,  rent  did  actually  come  to  exist  in 
spite  of  the  fact  that  demand  at  31  cents  was  less  than  20,000  bushels  ; 
and  then  to  show  that  this  rent  would  inevitably  be  eliminated 
through  the  spontaneous  working  of  economic  forces. 

Thus,  let  us  suppose  that,  though  the  demand  for  wheat  at  31 
cents  is  only  19,900  bushels,  there  has  actually  appeared  on  each  acre 
in  use  a  rent  of  20  cents  per  acre,  one  cent  for  each  bushel.  Since, 
under  this  supposition,  the  farmer's  outlay  for  each  bushel  amounts 
to  just  31  cents,  30  for  other  costs  and  i  for  rent,  the  actual  price 
must  be  at  least  at  high  as  31  cents,  else  production  would  not  go  on 


1  Or  wheat  will  be  taken  to  represent  agricultural  products  in  general. 


XXXVIII]  RENT  459 

at  all.  But  an  actual  price  of  31  cents  means  that  the  effective  de- 
mand will  be  only  19,900  bushels.  As  a  result,  only  995  out  of  the 
1,000  acres  of  land  will  be  wanted,  since  only  that  many  are  needed 
to  raise  the  19,900  bushels.  But  this  fact  will  make  5  acres  super- 
fluous; and  the  competition  of  these  five  acres  for  the  20  cents  rent 
will  reduce  that  rent  to  zero.  Thus,  the  existence  of  rent  is  not 
possible  so  long  as  the  demand  for  wheat  at  every  price  above  costs 
other  than  rent  is  not  as  great  as  the  total  possible  output.2 

We  have  seen  that,  under  our  present  hypothesis,  rent  could  not 
exist  so  long  as  the  demand  for  wheat  at  some  price  above  30  cents, 
say  31  cents,  had  not  come  to  be  as  great  as  20,000  bushels,  the  total 
capacity  of  the  land.  The  complementary  proposition,  that  rent 
would  begin  to  exist  as  soon  as  this  condition  was  fulfilled,  provided 
that,  in  addition,  the  demand  at  30  cents  were  greater  than  20,000 
bushels — this  proposition  is  easily  established.  As  soon  as  demand 
had  become  equal  to  20,000  bushels  at  31  cents,  while  greater  at  30 
cents,  the  buyers  who  were  ready  to  pay  31  cents  would  have  to  bid 
the  price  up  to  that  figure  in  order  to  exclude  the  excess  of  demand, 
thus  establishing  a  price  of  31  cents.  But,  at  this  price,  producers 
would  get  a  surplus  of  i  cent  on  each  bushel  or  20  cents  on  each 
acre ;  and,  since  prior  to  the  increase  in  demand,  the  producers  of 
wheat  could  afford  to  supply  it  at  30  cents,  this  surplus  of  20  cents 
per  acre  would  invite  competition  of  producers  from  other  indus- 
tries ;  some  part  of  the  2O-cent  surplus  would  be  offered  to  land- 
owners for  the  right  to  use  the  land ;  and  reciprocal  bidding  between 
possible  tenants  would  go  on  till  the  whole  surplus  had  been  turned 
over  to  the  landlord,  or  assured  to  him  if  he  were  his  own  tenant.3 


3  A  theoretic  complication  is  possible  in  which,  though  the  demand  at 
the  above-cost  price  is  not  as  great  as  the  possible  output,  the  demand  at 
cost  is  greater  than  output.  This  case  would  be  one  of  unstable  equilibrium. 
Price  must  rise  for  a  moment  above  cost  in  order  to  throw  out  a  part  of 
demand,  and,  in  doing  so,  it  would  bring  rent  into  existence.  But  this  could 
be  true  only  for  the  moment.  The  fact  that  demand  fell  below  capacity 
as  soon  as  price  rose  above  cost  would  again  bring  down  price  and  so 
annihilate  rent.  When  this  had  happened,  the  excess  of  demand  at  cost 
might  again  send  price  up  temporarily,  creating  rent  temporarily,  which 
would  again  be  eliminated  as  before.  And  so  this  alternation  might  go  on 
indefinitely. 

*  The  existence  of  rent  does  not  require  that  a  payment  should  be  made 
from  one  person  to  another.  The  surplus  over  cost  which  goes  to.  or  stays 
with,  the  landowner  is  itself  the  rent. 


460  PRINCIPLES  OF  ECONOMICS  [XXXVIII 

Summary. — The  above  explanation  of  rent  under  our  present 
very  unreal  hypothesis  may  advantageously  be  summarized  before 
leaving  it ;  for  it  contains  the  essence  of  the  explanation  of  rent  un- 
der any  set  of  conditions.  The  following  will  answer :  When  the 
demand  for  wheat  at  a  price  above  cost  has  become  as  great  as  the 
capacity  of  the  land,  and  demand  at  a  price  equal  to  cost  has  become 
greater  than  the  capacity  of  the  land,  the  actual  price  of  wheat  will 
rise  above  cost,  this  will  create  a  surplus,  and  the  competition  of 
possible  tenants  will  put  this  surplus  into  the  hands  of  the  land- 
owner, if  tenant  and  landowner  are  separate  persons,  and  fix  it  in 
the  hands  of  the  landowner,  if  these  two  are  united  in  the  same 
person. 

Putting  the  essence  of  the  matter  in  still  more  compressed  form, 
we  may  say  that  rent,  at  least  under  our  present  hypothesis,  would 
come  into  existence  when  and  because  the  possible  output  of  the  land 
proved  inadequate  to  satisfy  demand  except  at  some  price  higher  than 
cost  of  production. 

ILLUSTRATIVE  PROBLEMS 

1.  On  the  basis  of  the  hypothesis  just  used,  what  would  rent  per  acre 
be  under  each  of  the  following  demand  schedules  for  wheat?     (a)  18,000 
bushels  at  36  cents;  19,000  bushels  at  35  cents;  20,000  at  34  cents;  21,000 
at  33  cents;  22,000  at  32  cents;  and  so  on?     (b)     18,000  at  39  cents; 
19,000  at  38  cents;  20,000  at  37  cents;  21,000  at  36  cents;  and  so  on? 

2.  In  the  earlier  days  of  economic  study  it  was  thought  by  some  very 
able  men  that  the  existence  of  rent  proves  that  agriculture  is  an  especially 
productive  kind  of  industry.     When  the  true  explanation  of  rent  had 
been  given,  a  famous  economist  declared  that  rent  is  due,  not  to  the 
bounti fulness,  but  to  the  niggardliness  of  nature.     Defend  that  proposi- 
tion. 

Second  Hypothesis 

We  have  seen  how  rent  originates  in  the  very  simple,  but  very 
unreal,  case  furnished  by  our  first  hypothesis.  Let  us  now  change 
the  hypothesis  so  as  to  bring  it  a  step  nearer  to  the  facts  of  life. 
Let  us  suppose  that  the  wheat  land  of  our  island  is  not  all  of  one 
grade,  there  being  only  100  acres  of  the  grade  which  yields  20  bushels 


XXXVIII]  RENT  461 

per  acre  at  a  cost  of  30  cents,  while  the  rest  is  distributed  into  3 
parcels,  one  of  200  acres  which  will  produce  each  17  bushels  at  a 
cost  per  bushel  of  35  cents ;  another  of  300  acres  which  will  produce 
each  15  bushels  at  a  cost  per  bushel  of  40  cents ;  and  a  third  of  400 
acres  which  will  produce  each  13^  bushels  at  a  cost  per  bushel  of 
45  cents.  In  each  case,  greater  expenditure  would  make  no  increase 
in  output,  while  any  smaller  expenditure  would  produce  no  output 
at  all.  We  will  designate  these  different  grades,  3O-cent  land,  35-cent 
land,  4O-cent  land,  and  45-cent  land,  respectively. 

When,  now,  would  rent  appear  under  these  new  conditions? 
First,  it  is  quite  certain  that  there  could  be  no  rent  so  long  as  the 
demand  for  wheat  at  any  price  above  cost  on  the  3O-cent  land  has  not 
become  equal  to  the  possible  output  of  that  land,  2,000  bushels.  This 
proposition  is  plainly  analogous  to  the  first  one  laid  down  under 
the  previous  hypothesis,  though  this  time  the  crucial  figure  in  de- 
mand is  2,000  bushels,  the  possible  output  of  the  best  land,  instead  of 
20,000,  the  possible  output  of  all  the  land  under  the  previous  hy- 
pothesis. In  substance,  the  argument  for  this  proposition  is  the 
same  as  that  used  before.  Any  rent  which  might  temporarily  ap- 
pear under  the  conditions  given  would  soon  be  reduced  to  zero  by 
the  spontaneous  working  of  economic  forces.  The  paying  of  that 
rent  would  necessitate  an  actual  price  for  wheat  of  31  cents;  that 
price  would  reduce  actual  demand  to  less  than  the  possible  output 
of  the  3O-cent  land ;  this  reduction  in  demand  would  throw  out  of 
cultivation  some  of  said  3O-cent  land ;  and  the  competition  of  the 
thrown-out  acres  would  reduce  rent  to  zero. 

Again,  the  conditions  under  which  rent  will  appear  and  persist 
are  substantially  the  same  as  before.  Just  as  soon  as  the  demand 
for  wheat  at  some  price  higher  than  cost  on  the  best  land,  say  31 
cents,  had  become  equal  to  the  total  possible  output  on  that  land, 
2,000  bushels,  while  demand  at  the  cost  price,  30  cents,  had  become 
greater  than  2,000  bushels,  rent  would  begin  to  exist  on  the  best  land. 
For,  under  this  condition,  the  price  of  wheat  would  necessarily  be- 
come 31  cents;  this  would  give  a  surplus  over  cost  of  I  cent  per 
bushel  or  20  cents  per  acre;  and  the  competition  of  possible  tenants 
for  this  20  cents  would  insure  its  being  given  to,  or  left  with,  the 
landowner.  The  explanation  of  rent  is  thus  substantially  the  same 


462  PRINCIPLES  OF  ECONOMICS  [XXXVIII 

as  under  our  former  hypothesis.  That  is,  rent  comes  to  exist  when 
and  because  the  possible  output  of  the  best  land  proves  inadequate 
to  satisfy  the  increasing  demand  except  when  actual  price  has  risen 
to  a  point  above  cost  of  production  on  that  best  land. 

Inferior  Lands  Not  Cause  of  Rent. — What,  now,  is  to  be  said 
with  respect  to  the  relation  of  the  inferior  lands  of  our  present 
hypothesis  to  the  rent  problem?  If  we  have  in  mind  the  causation 
of  rent,  the  most  natural  answer  is  that  the  inferior  lands  have  no 
part  in  the  matter.  If  they  had  been  sunk  under  the  ocean  by  an 
earthquake,  if  they  had  never  existed,  rent  would  have  risen  just 
the  same  and  just  as  soon,  that  is,  as  soon  as  the  capacity  of  the  best 
land  had  proved  inadequate  to  satisfy  the  increasing  demand,  save 
as  that  demand  was  reduced  by  the  rising  of  actual  price  above  the 
cost  of  production  on  the  best  land.  But  it  is  possible  to  interpret 
the  affirmation  that  rent  depends  on  the  inferior  lands,  in  a  way 
that  makes  the  proposition  include  an  element  of  truth.  These 
inferior  lands  are,  after  all,  lands.  If  they  were  not  inferior,  we 
could  count  them  right  along  with  the  best  lands  as  adding  so  much 
to  the  total  stock  and  so  adding  to  the  total  possible  output  of  wheat, 
with  the  result  that  the  rising  of  the  price  of  wheat,  and  so  the  ap- 
pearing of  rent,  would  be  much  postponed.  The  reason  why  they 
cannot  be  so  counted  is  that  they  are  inferior.  Their  inferiority, 
then,  counts  indirectly  as  a  limitation  on  the  stock  of  best  lands. 
This,  however,  seems  like  a  very  back-handed  way  of  affirming  the 
fact  which  really  causes  rent,  namely :  the  fact  that  the  supply  of  the 
best  land  is  limited  to  100  acres. 

Inferior  Lands  Check  on  Rent. — The  above  paragraph  brings 
out  the  point  that  the  inferior  lands  have  no  part  in  the  origination 
of  rent.  Those  lands  do,  however,  play  a  very  important  role  in 
rent  determination,  namely:  limiting  the  amount  of  rent,  checking 
its  growth.  Thus,  if  there  had  been  no  35-cent  land  available,  then, 
as  soon  as  the  demand  for  wheat  had  so  increased  as  to  become 
2,000  bushels  at  36  cents,  the  price  of  wheat  would  necessarily  have 
risen  to  that  figure,  and  rent  would  have  advanced  to  $1.20  per  acre. 
Under  the  actual  hypothesis,  however,  the  result  is  quite  different. 


XXXVIII]  RENT  463 

When  the  price  of  wheat  reaches  35  cents,  it  becomes  profitable  to 
work  the  35-cent  land;  as  a  result  the  possible  output  becomes  5,400 
bushels  instead  of  just  2,000;  hence  the  price  of  wheat  cannot  rise 
to  36  cents,  though  the  demand  for  wheat  at  that  figure  has  reached 
2,000  bushels,  being  kept  instead  at  35  cents  as  long  as  demand  at 
36  cents  is  under  5,400;  and  so  the  surplus  and  rent  are  kept  from 
rising. 

ILLUSTRATIVE  PROBLEMS 

1.  The  existence  of  rent  does  not  require  that  there  should  be  differ- 
ences in  the  fertility  or  accessibility  of  the  land.     Defend  that  statement. 

2.  Why  would  rent  come  sooner  under  the  second  hypothesis  than 
under  the  first? 

Third  Hypothesis 

Let  us  now  bring  our  hypothesis  into  closer  accord  with  reality 
by  supposing  that  the  productivity  of  the  land  is  variable,  not  abso- 
lute, being  governed  by  the  principles  brought  out  in  Chapters 
IX,  X,  and  XL  Accordingly,  let  us  suppose  that  our  best  land 
does  not  show  a  cost  for  auxiliary  factors  as  low  as  30  cents  till 
the  land  has  been  worked  to  the  point  of  diminishing  returns; 
and  that,  after  this  point  has  been  reached,  a  new  expenditure  of  32 
cents  per  bushel  will  add  10  bushels  to  the  output  per  acre,  and  a 
further  new  expenditure  of  34  cents  per  bushel  will  add  5  bushels. 
In  short,  after  we  have  reached  the  point  of  diminishing  returns 
in  the  working  of  the  land,  we  shall  have,  on  each  acre  of  the  best 
land,  three  legitimate  productive  opportunities:  a  3O-cent  opportunity, 
a  32-cent  one,  and  a  34-cent  one;  and  we  shall  also  have  three 
possible  outputs:  2,000  bushels,  3,000  bushels,  and  3,500  bushels. 
\Yould  this  change  in  conditions  require  us  to  change  our  explana- 
tion of  rent?  In  essentials,  No.  As  before,  rent  would  emerge 
when  and  because  the  demand  for  wheat  at  a  price  higher  than  cost 
on  the  best  land  had  come  to  be  as  great  as  the  possible  output  on 
that  land.  This  time,  however,  a  more  explicit  statement  would  be 
needed.  Rent  would  emerge  when  and  because  the  demand  at  a 
price  higher  than  cost  on  the  best  land,  that  land  being  worked  only 
to  the  point  of  diminishing  returns,  had  come  to  equal  the  possible 


464  PRINCIPLES  OF  ECONOMICS  [XXXVIII 

output  of  that  best  land  worked  only  to  the  point  of  diminishing 
returns. 

The  reason  for  this  change  of  statement  is  fairly  obvious.  Of  the 
three  opportunities  present  on  the  best  land,  the  best,  that  is,  the 
cheapest,  will  be  first  utilized  and  will  yield  a  surplus  at  a  price 
which  would  be  too  low  to  justify  utilizing  the  other  opportunities 
at  all.  Thus  an  actual  price  for  wheat  of  31  cents  would  give,  on 
each  acre,  a  surplus,  and  so  a  rent,  of  20  cents,  though  an  actual 
price  of  32  cents  would  be  necessary  to  induce  farmers  to  utilize 
the  32-cent  opportunity. 

The  relation  of  the  inferior  opportunities  for  the  production  of 
wheat,  derivable  from  the  more  intensive  working  of  the  best  land, 
to  the  rent  problem  are  the  same  as  that  of  those  inferior  oppor- 
tunities which  are  derivable  from  the  poorer  grades  of  land.  In 
causing  rent,  they  have  no  part.  Rent  would  arise  at  the  same  time 
and  for  the  same  reason,  if  they  did  not  exist.  On  the  other  hand, 
they  play  an  important  part  in  checking  the  growth  of  rent.  Under 
our  previous  hypothesis,  rent  experienced  no  check  until  it  had  risen 
to  $i  an  acre,  that  is,  until  the  price  of  wheat  had  risen  to  35  cents 
and  so  justified  the  working  of  the  second  grade  land.  Now,  how- 
ever, there  is  a  32-cent  opportunity  on  the  best  land,  which  oppor- 
tunity can  be  utilized  as  soon  as  actual  price  reaches  32  cents ;  and, 
with  its  utilization,  demand  is  temporarily  satisfied,  the  rise  of  price 
is  checked,  and  so  the  growth  of  rent  is  checked  when  it  is  only  40 
cents  per  acre. 

Fourth  Hypothesis 

The  last  of  our  three  hypotheses  has  brought  us  much  nearer  the 
facts  of  the  real  world;  but  there  is  at  least  one  very  considerable 
point  of  difference  left.  Up  to  this  time,  the  several  costs  of  pro- 
ducing wheat  which  appear  in  the  second  and  third  hypotheses  have 
been  separated  by  considerable  intervals.  Under  the  second  hy- 
pothesis, they  differed  by  5  cents,  being  30,  35,  40,  etc.  Under  the 
third,  they  differed  less,  but  still  by  2  cents  most  of  the  time,  being 
30,  32,  34,  35,  etc.  Now,  it  can  scarcely  be  doubted  that  in  real  life, 
even  these  smaller  differences  are  too  great.  Very  likely  the  differ- 
ent costs  really  grade  into  one  another  almost  insensibly.  Since,  how- 


XXXVIII]  RENT  465 

ever,  producers  would  probably  not  be  influenced  in  the  amount 
they  produced  by  changes  less  than  one  cent,  let  us  suppose  that, 
under  the  successively  less  favorable  conditions  of  resort  to  poorer 
lands  and  more  intensive  cultivation,  the  costs  of  wheat  are  30  cents, 
31  cents,  32  cents,  33  cents,  etc.,  making  a  supply  schedule  for  our 
island  something  like  the  one  given  in  the  accompanying  table.  Would 
this  change  in  our  hypothesis  compel  a  change  PRICE  SUPPLY 

in  our  explanation  of  rent?    The  true  answer  is       30  2,000 

surely  a  negative  one.  ^  2,500 

33  3^500 

Real    Cause   Unchanged.— As   before,   the       34  4,ooo 

1  f  1  r  1  1  1  35  4>5°° 

real  cause  or  rent  is  the  fact  that  demand  at        36  5,000 

some  price  above  the  cost  of  production  on  the       37  5>5°o 

and  so  on 

best  land  when  cultivated  to  the  point  of  dimin- 
ishing returns — the  least  cost  before  rent  exists — is  equal  to  the  total 
possible  output  at  that  least  cost,  while  demand  at  a  price  just  equal 
to  least  cost  is  greater  than  the  total  possible  output  at  that  cost. 
The  fulfilment  of  this  condition  causes  actual  price  to  rise  above  the 
least  cost ;  and  thus  is  brought  into  existence  a  surplus  on  the  best 
land,  which  is  bound  to  go  to  the  landowner. 

But,  it  may  be  said,  under  this  new  condition  there  will  be  a  cost 
of  production  equal  each  time  to  the  price  which  demand  establishes  ; 
may  we  not,  therefore,  say  that  price  rises  and  so  develops  the  rent 
surplus  because  the  marginal  cost  has  increased?  The  answer  is  a 
negative  one.  When  demand  increases  till  it  is  2,000  bushels  at  31 
cents  and  2,100  at  30  cents,  the  price  rises  to  31  cents,  not  because 
the  latter  becomes  the  marginal  cost,  but  because  no  more  wheat  can 
be  produced  at  the  old  cost  of  30  cents.  Were  there  no  possibility 
of  producing  wheat  at  31  cents,  and,  therefore,  no  chance  that  this 
could  be  the  marginal  cost,  the  actual  price  would  just  as  certainly 
rise  to  31  cents,  and  just  as  certainly  cause  rent  to  emerge.  The 
correct  statement  of  the  case  is  this :  actual  price  rises  above  the 
least  cost  and  so  rent  emerges,  because  no  more  wheat  can  be  sup- 
plied at  the  said  least  cost.  But  the  appearance  of  the  price  which 
made  rent  also  justified  the  raising  of  wheat  at  the  next  higher  cost, 
which  raising  of  wheat  stopped  the  further  rise  of  price  and  so  the 
further  rise  of  rent,  thus  bringing  about  a  price  for  wheat,  and  so 


466  PRINCIPLES  OF  ECONOMICS  [XXXVIII 

a  rent,  in  tlie  fix-ing  of  which  the  demand  for  wheat  and  the  cost  of 
production  both  participated. 

Ill 
Rent  and  Disutility 

In  Chapter  XXVIII  it  was  maintained  that  the  disutility  cost 
involved  in  supplying  the  three  factors  of  human  origin,  labor, 
capital,  and  responsibility-taking,  had  a  part  in  determining  their 
price.  Can  the  same  be  said  of  the  price  of  the  services  of  land, 
that  is,  rent?  The  answer  is  of  course  a  negative  one.  In  order  to 
have  a  real  disutility  cost,  a  factor  must  be  of  human  origin ;  hence 
land,  which  is  not  of  human  origin,  can  have  no  disutility  cost.  A 
particular  piece  of  land  may,  like  any  other  factor  in  production, 
have  an  opportunity  cost.  If  it  is  needed  for  one  purpose  and  we 
desire  to  put  it  to  another  purpose,  the  advantage  of  the  former  will 
have  to  be  sacrificed,  and  this  fact  will  probably  have  a  part  in 
determining  the  price.  But  this  sacrifice  is  net  a  true  disutility  cost. 
It  follov.-s  that  rent  is  determined  solely  by  the  significance  or  utility 
of  land  or  its  services.  This  significance  or  utility  is  probably  for 
one  reason  or  another  more  easily  ascertained  for  land  than  for  any 
of  the  other  factors;  and  so  the  significance  or  service-value  prin- 
ciple is  more  fully  realized  for  land  than  for  labor,  capital,  or  re- 
sponsibility-taking. But  if  land  has  no  disutility  cost,  no  disutility 
cost  can  influence  its  price.  The  disutility  half  of  our  principle  has 
here  no  application. 

This  matter,  however,  should  not  be  left  without  further  com- 
ment. While  the  furnishing  of  land  services  involves  no  original 
disutility,  it  does  involve  derivative  disutilities.  Under  normal  con- 
ditions, the  market  price  of  any  piece  of  ground  will  approximately 
equal  the  capitalization  of  its  net  income.  In  consequence,  persons 
desiring  to  become  rent-receivers  will  be  obliged  to  invest  their  capi- 
tal in  the  land,  just  as  if  it  were  a  producible  commodity, — gaining 
the  position  of  a  rent-receiver  will  therefore  mean  assuming  the 
ordinary  capitalistic  disutilities,  abstinence,  waiting,  and  risk-taking. 
Further,  this  process  of  capitalizing  the  income  of  land  will  almost 
certainly  work  itself  out  in  such  a  way  that  the  income  pretty 


XXXVIII]  RENT  467 

closely  expresses  the  disutilities  created.  In  consequence,  it  might 
seem  that  we  ought  to  affirm  that  rent  must  be  so  determined  as  to 
be  an  expression  of  the  derived  disutilities  of  supplying  the  land 
services  for  which  it  is  received.  This,  however,  would  not  be  true. 
The  disutilities  follow  rather  than  precede  the  appearance  of  the 
rent.  Hence  they  have  no  share  in  determining  the  rent.  It  is 
rather  the  price  of  the  land  which  must  be  so  adjusted  as  to  make 
the  rent  an  expression  of  the  disutilities  involved  in  furnishing  land 
services. 


CHAPTER  XXXIX 

INTEREST 

The  subject  of  interest  has  probably  given  rise  to  more  theoretic 
analysis  than  any  other  part  of  economics.  This  is  due  partly  to 
the  serious  inherent  difficulties  of  the  subject,  partly  to  the  fact 
that  such  theoretic  analysis,  in  the  case  of  interest,  connects  itself 
with  certain  great  practical  controversies.  Of  these  controversies, 
the  most  important  concerns  the  ethical  legitimacy  of  interest.  From 
the  earliest  times  there  has  been  much  opposition  to  this  particular 
source  of  income  as  being  essentially  immoral.  This  opposition,  seek- 
ing to  strengthen  itself  theoretically  by  showing  that  there  are  no 
valid  grounds  on  which  the  existence  of  such  an  income  can  be  justi- 
fied, has  devoted  enormous  energies  to  the  study  of  the  nature  and 
origin  of  interest.  Thus  a  purely  practical  problem  has  given  im- 
mense stimulus  to  studies  purely  theoretical.  It  seems  best,  there- 
fore, that  we  should  here  enter  into  some  phases  of  the  subject  quite 
fully;  though  what  we  have  to  say  will  not  be  unfamiliar,  since  it 
has  been,  in  great  part,  anticipated  in  previous  discussions. 


The  Interest  Phenomenon 

Explicit  Interest. — Our  first  task  must  be  to  develop  clear 
and  definite  ideas  of  what  interest  is.  Its  most  familiar  manifesta- 
tion is  seen  in  connection  with  the  ordinary  money  loan.  A  lender 
puts  at  the  complete  disposal  of  a  borrower  a  sum  of  money;  this 
money  or  an  equivalent  sum,  is  to  be  returned  to  the  lender  after 
a  stated  period ;  and,  in  return  for  the  advantages  which  are  sup- 
posed to  accrue  to  him  from  this  operation,  the  borrower  makes  to 
the  lender  a  special  payment  amounting  to  a  small  per  cent  of  the 
sum  loaned  and  proportioned  to  the  length  of  time  for  which  the 

463 


XXXIX]  INTEREST  469 

loan  runs.     This  special  payment  is  of  course  the  interest  we  are 
talking  about. 

Implicit  Interest. — The  type  of  interest  jus/t  described  is 
commonly  called  contractual,  or,  sometimes,  explicit  interest.  It  is 
open,  avowed  interest.  But  there  are  besides  many  business  situa- 
tions in  which  interest,  though  just  as  truly  present,  is  more  or  less 
concealed — implicit  interest.  Consider  for  example  the  relation 
between  the  prices  of  ordinary  producible  goods  and  their  costs  in 
other  goods,  current  labor,  and  risk-taking.  Each  unit  of  product 
has  a  price  high  enough  to  cover  not  only  the  items  just  enumerated, 
but  also  interest  on  the  invested  capital, — the  sum  of  money  which 
the  entrepreneur  could  get  from  the  sale  of  his  whole  outfit.  This 
must  be  so,  the  business  man  would  say,  because  otherwise  no  one 
would  devote  his  money  to  manufacturing  commodities ;  instead, 
everyone  would  lend  it,  getting  contractual  or  explicit  interest. 

This  is  inadequate  if  it  is  meant  to  be  a  complete  explanation  of 
interest ;  for  sums  of  money  are,  so  to  speak,  merely  formal  capital ; 
and  the  deeper  explanation  must  be  found  in  the  interrelations  of 
those  things  which  borrowed  money  is  used  to  buy  rather  than  in 
money  relations  as  such.  But  it  contains  this  much  truth  :  It  is  in  the 
market  for  money-loans  that  the  various  forces  which  are  causing 
interest  to  exist  and  determining  its  rate,  most  completely  manifest 
themselves.  Accordingly,  the  business  man's  method  of  arguing  at 
this  point  supplies  a  clue  which  will  often  tell  us  where  to  look  for 
implicit  interest.  Wherever  we  find  a  person  occupying  an  economic 
relation  which  deprives  him  of  an  opportunity  to  make  money 
loans  and  receive  explicit  interest  therefor,  we  may  be  sure  he  is  in 
some  way  receiving  implicit  interest. 

ILLUSTRATIVE  PROBLEMS 

1.  How  does  the  interest  phenomenon  manifest  itself  in  the  price  of 
a  dwelling  house? 

2.  In  the  hire   (rent)   of  such  a  house? 

3.  In  the  price  of  a  building  site  ? 

4.  In  the  fares  charged  by  a  steamship  in  the  transatlantic  service? 


470  PRINCIPLES  OF  ECONOMICS  [XXXIX 

II 
Essential  Nature  of  the  Interest  Phenomenon 

The  surface  marks  of  the  interest  phenomenon  have  probably 
been  shown  with  sufficient  distinctness  in  the  preceding  discussion. 
When,  however,  we  inquire  as  to  the  real  inner  nature  of  interest  we 
find  ourselves  beset  with  more  serious  difficulties.  Out  of  a  rather 
confused  mass  of  writing  on  this  subject  we  may  distinguish  two 
principal  theories :  the  use  theory  and  the  exchange  theory.1 

The  Use  Theory. — The  use  theory  is  almost  universal  in  the 
business  world  and  is  still  widely  held  by  economists.  According  to 
this  doctrine,  interest  is  a  payment  for  the  use  of  capital ;  capital  be- 
ing conceived  either  as  a  sum  of  money  or  as  money  value  embodied 
in  some  capital  good.  If  a  manufacturer  borrows  on  his  ninety-day 
note  $600  to  buy  200  tons  of  coal  for  his  engines,  he  obviously  gets 
all  the  uses  of  the  coal  but  in  addition  he  may  be  said  to  get  a  ninety- 
days'  use  of  the  $600  embodied  in  the  coal.  Similarly,  if  Mr.  Elder 
buys  a  $1,200  automobile  on  a  one-year  note,  he  enjoys  all  the 
services  which  any  cash  buyer  could  realize  from  the  machine  and 
in  addition  he  is  thought  of  as  having  the  use  of  $1,200  for  a  year's 
time. 

The  Exchange  Theory. — In  explaining  the  exchange  theory, 
our  best  procedure  perhaps  is  to  begin  by  pointing  out  the  fault  in 
the  use  doctrine.  No  one  denies,  of  course,  that  the  borrower  or 
the  credit  buyer  gets  some  advantage,  service,  or  utility,  in  addition 
to  the  services  of  the  coal  or  the  automobile;  if  he  did  not,  he 
surely  would  not  pay  the  interest.  But  the  use  theory,  many  thinkers 
affirm,  errs  in  its  method  of  characterizing  this  advantage.  The 
advantage  of  the  man  who  buys  goods  with  borrowed  money  or  on 
credit  consists,  not  in  receiving  a  greater  sum  of  utilities  than  the 


1  It  is  not  uncommon  to  conceive  these  as  two  different  ways  of  explaining 
interest.  I  do  not  consider  this  view  justified.  The  real  explanation  given 
by  writers  from  each  of  the  two  groups  is,  in  most  cases,  substantially  the 
same. 


XXXIXJ  INTEREST  471 

men  who  buy  similar  goods  with  their  own  money  or  for  cash,  but  in 
paying  what  is  to  him  a  smaller  price.  He  enjoys  all  the  preroga- 
tives of  a  man  who  has  acquired  ownership  in  goods  by  the  process 
of  purchase,  although  he  has  not  made  the  complementary  sacrifice 
naturally  involved  in  a  purchase, — has  not  in  the  deepest  sense  bought 
the  goods  at  all.  In  short,  his  additional  advantage  over  the  non- 
credit  buyer  consists  in  postponing  the  sacrifice  necessary  to  becom- 
ing the  rightful  owner  of  the  utilities  of  the  goods. 

The  exchange  theory  as  to  the  nature  of  interest  will  now  be 
readily  comprehended.  Interest,  it  affirms,  is  in  reality  a  bonus,  a 
premium,  a  something  to  boot  which  the  man  who  buys  goods  now 
but  does  not  himself  pay  for  them  till  some  future  time,  gives  to  the 
person  who  enables  him  to  effect  this  transaction.  Or,  looking  at 
the  operations  from  the  lender's  side,  interest  is  a  bonus  or  premium 
which  the  man  who  relinquishes  his  right  to  goods  now  but  gets  his 
pay  only  at  a  later  date,  receives  for  making  this  exchange.  To  put 
the  theory  in  more  conventional  form :  Whenever  present  goods  are 
exchanged  for  future  goods,  a  bonus  or  premium  is  paid  by  the  party 
who  brings  to  the  exchange  future  goods,  to  the  party  who  brings 
present  goods;  and  this  bonus  or  premium  constitutes  interest.  Ob- 
viously, this  description  best  applies  to  contract  interest,  where  one 
particular  kind  of  goods,  especially  money,  is  borrowed  with  the 
understanding  that  just  the  same  kind  of  goods  is  to  be  returned  after 
a  stated  interval.  But  the  advocates  of  this  phraseology  hold  that  it 
describes  the  real  nature  of  every  transaction  wherein  interest  figures 
at  all,  even  to  the  most  obscure  cases  of  implicit  interest.  The  entre- 
preneur who  buys  raw  materials,  machinery,  and  labor,  and  com- 
bines these  to  produce  shoes  is  in  effect  exchanging  present  for  fu- 
ture goods;  for  the  raw  materials,  machinery,  and  labor,  though 
literally  existing  in  the  present,  are  not  truly  present  goods,  but  only 
future  goods,  shoes  in  the  making,  shoes  to  be. 

Into  the  real  merits  of  this  controversy  between  the  use  and  ex- 
change theories,  it  will  scarcely  pay  us  to  enter.  In  general,  we  shall 
asume  that  the  antithesis  between  the  two  is  not  as  great  as  their 
respective  advocates  imagine.  The  man  who  exchanges  present  for 
future  goods  must,  as  a  condition  of  doing  so,  be  in  a  position  to 
wait, — he  must  have  a  surplus  of  wealth  which,  measured  in  value, 


472  PRINCIPLES  OF  ECONOMICS  [XXXIX 

equals  the  goods  he  exchanges  for  future  goods.  Speaking  figura- 
tively, such  a  man  must  be  the  owner  of  waiting  power,  carrying 
power;  and,  this  will  usually  be  in  the  form  of  general  wealth, — 
money  or  claims  to  receive  money.  To  say  that  he  sells  the  use  of 
waiting  power  does  not  seem  essentially  different  from  saying  that 
he  exchanges  present  for  future  goods. 

Ill 
How  Interest  Comes  to  Exist 

Requisites  of  an  Explanation. — In  beginning  the  explanation 
of  interest,  it  is  natural  to  make  a  remark  similar  to  that  with  which 
we  introduced  the  explanation  of  rent.  Interest  exists  because  the 
demand  (at  some  price  above  zero)  for  a  certain  thing  is  in  excess  of 
the  output  of  that  thing — in  other  words,  because  there  is  an  extra- 
marginal  demand  for  it.  To  explain  the  value  of  any  object  we 
have  only  to  show  that  there  are  good  reasons  why  there  should  be 
a  demand  for  that  object  and  good  reasons  why  the  supply  should 
be  limited.  We  are  not  called  on  to  show  that  it  must  have  value,  but 
only  to  point  out  the  conditions  which,  if  fulfilled,  will  insure  its 
having  value.  In  the  case  before  us,  the  thing  commanding  a  price 
is  the  service  of  carrying  society's  stock  of  reserve  goods.  In  gen- 
eral, then,  our  task  is  to  show  (i)  why  there  would  naturally  be  a 
demand  for  carrying  power, — of  its  equivalent  loanable  money 
funds, — and  (2)  why  the  supply  of  this  service  would  naturally  be 
limited. 

Why  Waiting  Power  is  Demanded. — Among  the  reasons 
why  there  would  naturally  be  a  demand  for  waiting  power  are  the 
following:  (i)  Overestimate  of  the  importance  of  present -wants 
(spendthrift  borrowing),  (2)  anticipated  increase  in  income,  and 
(3)  the  superiority  of  time-consuming  methods  in  the  production  of 
goods  or  services. 

The  first  of  these  reasons  needs  little  comment.  Overestimation 
of  present  as  compared  with  future  wants,  the  conviction  that  one's 
immediately  pressing  desires  are  important  above  all  things  else  and 
must  be  satisfied — this  may  be  a  foolish  reason  for  borrowing,  but 


XXXIX)  INTEREST 


473 


it  is  plainly  a  very  real  one.  The  second  reason  is  almost  equally 
familiar.  Many  people,  particularly  the  young,  think  themselves 
justified  in  borrowing,  even  if  only  to  have  a  little  more  pleasure  in 
the  passing  hour,  because  they  confidently  anticipate  larger  incomes 
in  the  near  future. 

The  third,  and  much  the  strongest,  reason  why  there  is  a  demand 
for  carrying  power,  waiting  power,  is  to  be  found  in  the  fact  that 
the  control  of  such  power  enables  us  to  increase  enormously  our 
productive  efficiency.  The  chief  reasons  why  this  is  true  were 
brought  out  in  Chapter  V,  when  we  were  illustrating  the  function 
of  capital  as  a  factor  in  production  additional  to  labor  and  land. 
High  productive  efficiency  requires  that  we  should  maintain  a  vast 
fund  of  reserve  goods,  goods  devoted  to  the  service  of  the  future. 
The  desire  to  attain  this  efficiency  leads  us  to  come  on  the  market 
as  buyers  of  the  right  to  use  the  surplus  wealth  which  constitutes 
capital. 

Why  Quantity  of  Waiting  Power*  Is  Limited. — I  have  dwelt 
on  various  reasons  why  there  would  naturally  be  a  demand  for  wait- 
ing power,  carrying  power.  It  is  equally  easy  to  show  that  there 
would  naturally  be  a  limitation  on  the  supply.  As  we  already  know, 
the  ability  to  furnish  this  service  of  carrying  depends  on  the  ac- 
cumulation of  a  reserve  fund  of  goods  or  money,  and  this  accumu- 
lation can  be  made,  in  the  last  analysis,  only  through  saving.  But 
there  are  limits  to  the  total  saving  capacity  of  a  community.  In  the 
first  place,  the  amount  which  a  community  could  set  aside  for  the 
future  would  of  necessity  always  be  limited  by  the  total  income; 
we  could  not  conceivably  save  more  than  the  total  product  of  our 
efforts.  But,  again,  we  could  not  by  any  possibility  devote  even 
this  total  product  to  providing  for  the  future,  for  some  of  our 
present  wants  can  go  unsatisfied  only  at»the  cost  of  life.  Further, 
it  would  be  folly  to  sacrifice  any  present  needs  for  the  sake  of  future 
ones  which  were  not  of  equal  importance.  Accordingly,  a  wise  econ- 
omy would  never  build  up  the  stock  of  carrying  power  for  the  satis- 
faction of  future  wants  from  that  part  of  the  current  income  which 
is  needed  to  satisfy  present  wants  of  more,  or  even  equal,  impor- 
tance. 


474  PRINCIPLES  OF  ECONOMICS  [XXXIX 

The  share  of  current  income  which  can  be  devoted  to  the  service 
of  the  future  is  further  limited  by  the  fact  that  future  needs  of  a 
certain  degree  of  intensity  are  not  really  as  important  as  present 
needs  of  the  same  degree  of  intensity.  For  this  there  are  two 
reasons,  (i)  Life  itself  is  uncertain;  the  present  we  have,  the 
future  may  for  us  never  exist.  A  perfectly  sensible  and  prudent 
person,  therefore,  will  refuse  to  sacrifice  a  present  want  of  a 
certain  magnitude  for  a  future  one  of  the  same  magnitude.  (2) 
Gratification  of  the  present  want  is  sometimes  a  condition  necessarily 
precedent  to  the  future  want.  Thus,  the  gratification  of  the  present 
want  may  be  essential  to  the  continuance  of  life,  or  at  least  to  the 
maintenance  of  that  degree  of  physical  and  mental  health  which 
alone  can  fit  us  for  the  enjoyment  of  the  future  gratification. 

But,  even  if  present  and  future  wants  of  the  same  magnitude 
were  equally  important,  we  should  still  have  a  check  on  our  pro- 
cesses of  saving.  This  consists  in  the  same  tendency  we  have  cited 
as  a  cause  for  the  rise  of  demand  for  carrying  power;  namely,  the 
almost  universal  overestimate  of  the  importance  of  present  wants, 
the  almost  universal  underestimate  of  the  importance  of  future 
wants.  For  the  same  reason  that  borrowers  borrow,  savers  are  dis- 
inclined to  save  anything  to  lend  them.  Not  to  gratify  the  want  of 
today  seems  an  unbearable  hardship,  while  we  contemplate  without 
misgiving  the  deprivation  of  tomorrow.  No  doubt  there  are  indi- 
viduals to  whom  these  remarks  do  not  apply ;  some  people  accumu- 
late much  even  with  small  incomes.  But  most  of  us  spend  freely 
or  even  carelessly ;  and,  as  a  result,  the  supply  of  the  carrying  power, 
the  savings  of  the  community  for  the  future,  accumulates  less 
rapidly  than  it  would  if  prudence  in  such  matters  were  universal. 

We  have  thus  shown  why  it  is  natural  that  there  should  be,  on  the 
one  hand,  a  demand  for  carrying  power,  and,  on  the  other  hand,  a 
limitation  of  the  supply.  This  does  not  prove  that  there  must  be 
interest.  To  prove  that,  we  should  need  to  show  that  the  conditions 
tending  to  build  up  a  demand  for  carrying  power  and  those  tending 
to  limit  the  supply  of  carrying  power  are  so  potent  that  they  neces- 
sarily make  the  demand  at  some  rate  of  interest  above  zero  greater 
than  the  supply  at  that  rate.  To  prove  anything  of  this  kind  would 
be  from  the  nature  of  the  case  impossible.  However,  as  was  pointed 


XXXIX]  INTEREST  475 

out  in  an  earlier  paragraph,  we  are  not  called  on  to  undertake  such 
a  task.  Our  business  here  is  to  explain  interest.  This  does  not  re- 
quire us  to  prove  that  interest  must  exist,  but  only  to  name  the  con- 
ditions which,  if  fulfilled,  will  cause  it  to  exist — and  this,  plainly, 
we  have  done. 

ILLUSTRATIVE  PROBLEMS 

1.  "That  capital  is  productive  has  often  been  questioned,  but  no  one 
would  deny  that  tools  and  other  materials  of  production  are  useful;  yet 
these  two  propositions  mean  exactly  the  same  when  correctly  understood." 

Show  that  those  persons  who  object  to  calling  capital  productive 
would  hardly  be  satisfied  with  the  above  proof. 

2.  Suppose  that  a  fisherman  could  catch  21  fish  a  day  without  the 
aid  of  a  net  or  boat  or  any  other  form  of  capital ;  that  to  make  a  net 
would  cost  him  30  days'  labor ;  and  that  it  would  last  only  30  days. 

(a)  What  is  the  smallest  number  of  fish  which  the  net  must  enable 
him  to  catch  each  day  in  order  to  make  it  possible  for  us  to  credit  any 
portion  of  the  product  to  capital  as  capital? 

(b)  Supposing  that  the  fisherman  catches  with  the  aid  of  the  net 
200    fish    a   day,    what    is   the    maximum   productivity    which    could    be 
credited  to  the  capital  as  capital? 

(c)  Under  what  circumstances  would  that  maximum  tend  to  be  so 
credited  to  capital  ? 

(d)  Supposing  that  only  1,000  fish  were  actually  credited  to  the  net 
as  its  product,  how  would  you  explain  the  fact? 

(e)  Can  you  imagine  a  condition  of  things  under  which  no  part 
of  the  catch  would  be  credited  to  the  net? 

3.  In  order  that  we  should  impute  productivity  to  capital,  is  it  neces- 
sary that  some  part  of  the  capital  supplied  have  a  cost  of  abstinence? 

IV 
Interest  and  the  Significance-Disutility  Principle 

Interest  and  Significance. — We  argued  in  the  preceding 
chapter  that  the  economic  share  known  as  rent  is  with  special  ease 
brought  into  correspondence  with  the  economic  significance  of  the 
service  rendered  by  land.  We  might  almost  as  well  have  chosen 
interest  as  being  peculiarly  submissive  to  our  principle.  Almost  ev- 
erywhere the  capital  market  is  especially  free  from  interference,  is 


476  PRINCIPLES  OF  ECONOMICS  [XXXIX 

especially  characterized  by  freedom  of  competition.  If,  then,  the 
reasoning  of  Chapter  XXX  be  accepted, — the  reasoning  that  under 
complete  freedom  of  competition  the  price  of  each  primary  factor 
inevitably  tends  to  be  one  which  expresses  the  marginal  significance 
of  that  factor — we  may  be  quite  certain  that  this  is  true  of  interest, 
the  price  of  the  use  of  capital. 

There  is,  to  be  sure,  probably  no  method  of  ascertaining  directly 
and  definitely  the  product-significance  of  a  given  unit  of  capital. 
Not  a  few  writers  believe  such  a  method  to  exist,  but  I  do  not  share 
their  conviction.  The  economic  significance  of  capital  does  not 
manifest  itself  in  the  same  tangible  way  as  does  that  of  land. 

Nevertheless,  the  automatic  process  which  we  depended  on  in 
Chapter  XXX  to  make  the  prices  of  primary  factors  express  their 
marginal  significance  here  operates  freely  and  fully.  On  every  side 
opportunities  arise  for  the  use  of  capital  in  order  to  substitute  ma- 
chinery for  labor.  The  advantage  or  disadvantage  of  such  substitu- 
tion turns  finally  on  the  rate  of  interest,  the  price  of  the  use  of 
capital.  Entrepreneurs  compete  or  refuse  to  compete  for  the  sup- 
plies of  capital  according  as  its  price  does,  or  does  not  permit  a  profit 
on  its  use.  So,  the  owners  of  that  capital  openly  compete  against 
each  other  to  insure  its  employment.  If  its  price  exceeds  its  mar- 
ginal significance,  some  portion  of  the  supply  will  soon  cease  to  be 
employed.  If  its  price  is  below  its  marginal  significance,  marginal 
and  intra-marginal  users  will  have  to  bid  it  up  to  shut  out  the  extra- 
marginal  users.  Entrepreneurs  may  be  individually  and  collectively 
in  complete  ignorance  as  to  the  real  marginal  significance  of  capital ; 
but  they  have  no  difficulty  ascertaining  whether,  at  a  given  rate  of 
interest,  they  can  advantageously  bid  for  more  capital.  Paying  no 
attention  to  anything  other  than  their  own  immediate  profit,  their 
spontaneous  action  finally  brings  the  rate  of  interest  to  a  point  -where 
it  expresses  the  advantage  of  the  marginal  opportunity  for  the  use 
of  capital. 

Interest  and  Disutility. — Is  the  rate  of  return  to  capital  gov- 
erned also  by  the  disutility  principle?  Undoubtedly,  as  we  have 
already  argued  more  than  once,  the  supplying  of  capital  does  necessi- 
tate some  sacrifice  or  disutility.  The  question  remains  as  to  whether 


XXXIX]  INTEREST  477 

the  marginal  portion  of  this  sacrifice  is  expressed  by  the  rate  of 
interest.  Doubtless  a  negative  answer  is  possible.  The  volume  of 
capital  accumulation  is  influenced  by  other  conditions  than  the  rate 
of  interest.  For  example,  some  persons  are  in  a  position  to  save 
from  the  present  income  without  appreciable  sacrifice  while,  at  the 
same  time,  they  desire  to  provide  a  surplus  for  the  future.  Such 
persons  would  accumulate  capital  even  if  they  were  obliged  to  pay 
for  the  privilege.  It  is,  therefore,  conceivable  that  the  amount  of 
capital  actually  supplied  to  the  market  is  not  influenced  to  any  great 
extent  by  a  regard  to  the  interest  paid.  If  not  strictly  a  fixed-output 
good,  it  would  have  its  fluctuations  of  output  determined  through 
forces  other  than  cost.  The  price  of  its  use,  therefore,  would  not 
have  to  conform  in  any  degree  to  the  sacrifice  of  saving  it. 

But,  while  this  state  of  things  is  conceivable,  it  surely  does  not 
exist  in  fact.  One  type  of  accumulation,  certainly,  is  motived  by 
considerations  of  direct  economic  gain.  I  mean  the  getting  to- 
gether of  a  small  sum  to  make  a  start  in  business  or  speculation. 
Doubtless  we  are  not  here  dealing  with  pure  interest — the  profit  ex- 
pected is  the  more  important  item.  Still  the  interest  problem  is  also 
present,  since  the  entrepreneur  who  puts  his  own  capital  into  a  busi- 
ness cannot  help  performing  the  waiting  function  as  well  as  the 
responsibility-taking  function.  Now,  every  year  a  large  amount  of 
capital  comes  into  existence  in  this  way ;  and  it  is  hard  to  believe 
that  such  capital  has  no  influence  in  determining  the  rate  of  interest. 

But,  finally,  the  accumulating  of  that  portion  of  capital  which  is 
devoted  to  earning  interest  only  must  be  materially  influenced  by 
the  immediate  reward  in  the  shape  of  interest.  Surely  there  are  not 
a  few  people  in  such  a  position  that  they  naturally  say :  The  rate 
of  interest  has  fallen  so  low  that  it  really  is  not  worth  my  while  to 
save  any  more ;  I  would  better  enjoy  the  present.  If  so,  their  de- 
cision for  or  against  further  saving  must  change  the  volume  of 
capital  sufficiently  to  modify  its  price.  Putting  the  matter  in  a 
still  different  way,  can  we  seriously  doubt  that  a  fall  in  the  rate  of 
interest  to  zero  would  diminish  the  stream  of  new  capital,  or  that 
a  rise  to  ten  per  cent  would  increase  that  stream?  If  not,  then  we 
must  say  that  the  price  of  the  use  of  capital  must  tend  to  express 
the  marginal  disutility  of  supplying  it. 


478  PRINCIPLES  OF  ECONOMICS  [XXXIX 


The  Rate  of  Interest  and  the  Quantity  of  Money 

In  the  Long  Run. — Besides  the  general  theoretic  questions 
respecting  interest  already  considered,  there  are  one  or  two  of  a 
more  practical  sort  which  claim  our  attention.  A  very  persistent 
and  troublesome  popular  fallacy  makes  the  rate  of  interest  to  vary 
inversely  as  the  quantity  of  money;  whereas  of  course  the  more 
ultimate  causes  determining  interest  are  found,  not  in  the  demand 
and  supply  conditions  of  mere  money,  but  in  those  of  real  capital, 
such  as  engines,  machines,  and  lumber.  This  fallacy  seems  to  spring 
from  a  popular  confusion  of  money  and  capital.  It  is  not  unnatural 
in  view  of  the  fact  that  capital  is  always  marketed  in  the  immediate 
form  of  money  or  the  money  equivalent,  bank  credit.  As  a  matter 
of  fact,  we  may,  in  the  long  run,  safely  take  as  our  guide  to  the 
interest  relations  prevailing  among  real  capital  goods,  the  market 
for  mere  money  capital.  But  this  is  only  because  in  the  long  run 
those  interest  relations  prevailing  among  the  real  capital  goods  find 
full  expression  in  the  market  for  money  capital.  In  the  actual 
determination  of  interest  the  quantity  of  money  plays  little  part. 

The  argument  is  simple.  What  the  borrower  really  wants  is  not 
money  but  goods, — engines,  cars,  rails,  labor ;  and  putting  out  more 
coin  or  more  paper  money  will  not  make  these  goods  cheaper  to 
borrowers,  nor  will  the  withdrawal  of  money  make  them  dearer.  Or, 
if  we  suppose  the  rate  of  interest  to  be  lowered  at  first  by  an  in- 
crease of  money,  the  natural  working  of  things  will  soon  reverse 
the  movement,  (i)  The  lower  rate  will  lead  to  extensive  borrowing 
and  buying  of  goods.  (2)  This  will  raise  the  prices  of  goods;  since 
they  have  not  increased  though  the  money  has.  (3)  This  will  com- 
pel borrowers  to  borrow  more  money  in  order  to  get  the  same 
amount  of  goods.  (4)  This  will  raise  the  rate  of  interest  again  to 
its  former  place.2  Summarizing,  we  have  the  following  principle: 


1  In  fact,  it  is  generally  held  that,  when  the  stock  of  money  is  increasing, 
the  expected  fall  in  its  value — rise  in  prices — will  cause  lenders  to  hold  back 
for  a  higher  rate  of  interest  in  order  to  insure  themselves  against  loss  on 
the  principal. 


XXXIX]  INTEREST  479 

Principle.  In  the  long  run,  the  rate  of  interest  must  be 
determined  in  substantial  independence  of  the  quantity  of 
money. 

For  Short  Periods. — But,  while  in  the  long  run  we  cannot 
expect  to  influence  materially  the  rate  of  interest  by  altering  the 
quantity  of  money  in  circulation,  we  can  for  brief  periods  accom- 
plish this  result.  In  fact  governments  and  powerful  banks  at  times 
consider  it  one  of  their  functions  to  manipulate  the  money  stock  for 
l!:e  express  purpose  of  raising  or  lowering  the  rate  of  discount. 
Thus  the  Bank  of  England  has  in  several  instances  contracted  the 
circulation  of  London  in  order  to  force  on  the  market  a  higher  rate. 
The  possibility  of  bringing  about  such  results  in  the  way  indicated 
rests  upon  the  following  facts. 

Short-time  loans  largely  connect  themselves  with  the  need  for 
money,  not  to  invest  productively,  but  to  meet  money  obligations. 
The  demand  is  thus  emphatically  for  money  itself,  not  something 
which  money  will  buy.  Hence  the  short-time  rate  adjusts  itself  to 
the  marginal  utility  of  money  capital,  without  much  regard  to  goods 
capital.  Emphasis  rests  also  on  the  fact  that  the  short-time  rate 
adjusts  itself  to  the  marginal  utility  of  money  capital  with  little  re- 
gard to  the  disutility  of  saving.  This  is  simply  the  old  case  of  short- 
time  normals  being  determined  without  respect  to  cost  of  production. 
During  a  series  of  years,  the  price  of  wheat  tends  to  equal  its 
marginal  cost  of  production.  But  between  two  harvests  its  price 
tends  to  be  one  expressing  the  marginal  utility  of  the  existing  stock. 

Principle.  For  short  periods  (a  few  weeks  or 
months},  the  rate  of  discount  (interest}  tends  to  equal  that 
rate  which  expresses  the  marginal  utility  of  the  stock  of 
money  capital  without  much  regard  to  the  marginal  utility 
of  goods  capital  or  the  disutility  of  saving. 

VI 
The   Rate   of   Interest   and    Risk 

At  any  one  time  the  rate  of  interest  on  capital  used  for  the  same 
general  purpose  differs  greatly  in  different  places,  say  Ann  Arbor 


480  PRINCIPLES  OF  ECONOMICS  [XXXIX 

and  Spokane ;  and  even  in  the  same  place  at  the  same  time  it  per- 
haps differs  widely  when  the  capital  is  put  to  different  uses.  The 
chief  explanation  of  these  differences  is  doubtless  inequality  in  the 
matter  of  risk.  The  excess  over,  say,  four  per  cent  in  a  given  time 
and  place  may  be  conceived  as  an  insurance  premium,  necessary  to 
cover  losses  from  bad  debtors,  or  perhaps  as  a  payment  necessary 
to  overcome  the  natural  indisposition  of  the  lender  to  take  chances. 
If  we  understand  by  "gross  interest"  the  amount  actually  paid  and 
by  "pure  interest"  the  rate  to  cover  the  simple  use  of  capital,  we 
may  lay  down  the  following  principle,  which  though  obvious  and 
familiar,  is  unfortunately  often  overlooked. 

Principle.  The  amount  by  which  gross  interest  in  any 
particular  case  exceeds  pure  interest  tends  to  vary  roughly 
as  the  risk  involved. 


CHAPTER  XL 

WAGES 

As  was  the  case  with  rent  and  interest,  wages  constitute  the 
price  of  one  of  the  primary  factors.  It  follows  that  the  general 
argument  for  the  dominance  of  the  significance-disutility  principle 
over  this  share  in  distribution  was  implicit  in  Chapters  XXVIII  to 
XXX  when  we  were  showing  that  the  prices  of  primary  factors  in 
general  are  determined  by  this  principle.  In  the  present  connection, 
therefore,  we  need  only  to  comment  briefly  on  some  facts  which 
tend  to  modify  more  or  less  the  workings  of  the  general  principle. 
We  will  comment  first  on  matters  which  seem  to  interfere  with  the 
significance  half  of  the  price. 


Wages  and  Significance 

Labor  Organizations. — One  of  the  most  important  obstacles 
to  the  complete  domination  of  the  significance  principle  in  the  case 
of  wages  is  the  fact  that  there  is  more  or  less  restraint  put  on 
competition  by  those  who  supply  labor  services :  in  a  good  many 
occupations,  something  like  a  labor  monopoly  exists.  Restriction  is 
secured  both  by  limiting  the  number  of  laborers  in  a  given  field  and 
by  limiting  through  various  devices  the  natural  output  of  those  per- 
sons who  do  get  into  the  field.  As  a  result,  the  share  of  these 
persons  tends  to  exceed  that  which  would  express  the  marginal 
significance  of  the  natural  output  of  their  type  of  service.  In  short, 
society  has  to  pay  for  many  of  the  higher  services  more  than  would 
be  expected  in  view  of  the  amount  of  those  services  which  would 
naturally  be  forthcoming.  Laborers  who  supply  the  services  get 
more  than  they  earn,  using  the  latter  term  in  its  ordinary  sense. 

We  need  not,  however,  take  this  concession  too  seriously.  In 

481 


482  PRINCIPLES  OF  ECONOMICS  [XL 

this  age  of  publicity,  free  education,  and  universal  initiative,  few 
combinations  could,  in  the  long  run,  be  successful  in  shutting  out  the 
competition  of  the  really  fit.  Further,  the  policy  of  the  trades  unions 
is  to  some  extent — though  certainly  not  a  large  one — offset  by  an 
analogous  procedure  on  the  part  of  employers.  Adam  Smith,  the 
so-called  father  of  Political  Economy,  said  that  there  always  exists 
a  universal,  though  tacit,  combination  among  employers  to  keep 
wages  down.  This  was  probably  nearer  the  truth  in  his  day  (1776) 
than  now.  The  vastly  greater  extent  of  the  market  within  which 
labor  is  bought  and  sold  now  makes  tacit  combination  almost  im- 
possible; and  formal  combination  for  this  end  seems  not  to  have 
been  carried  far.  Still  there  is  probably  enough  to  offset  in  some 
measure  the  monopolistic  combinations  of  labor.  In  short,  it  is 
probably  safe  to  assume  that  the  wages  of  even  the  higher  forms 
of  manual  labor  are  not  priced  at  a  point  materially  above  their 
natural  marginal  significance. 

Immobility  of  Labor. — Another  obstacle  to  the  complete 
domination  of  wages  by  the  significance  principle  is  the  lack  of  mo- 
bility among  laborers.  We  have  all  noted  that  the  mere  competition 
of  sellers  will  not  secure  the  advantage  of  buyers  unless  the  latter 
are  themselves  reasonably  alert.  A  shop  may  advertise  ever  so  con- 
spicuously the  fact  that  it  sells  the  same  wares  at  prices  below  those 
of  its  rivals;  but,  unless  buyers  note  the  fact  and  act  accordingly, 
they  will  not  benefit  from  the  favorable  competition.  But  the  con- 
verse proposition  is  also  true.  The  mere  competition  of  buyers  will 
not  insure  good  prices  to  sellers  unless  the  latter  are  alert  enough 
to  become  cognizant  of  the  fact,  and  are  in  a  position  to  profit  by 
their  knowledge.  Ignorance,  lack  of  means,  inertia — by  all  of  which 
laboring  men  are  too  frequently  hampered — may  combine  to  neutral- 
ize more  or  less  completely  the  advantage  which  they  might  derive 
from  the  free  competition  of  employers. 

Custom. — Another  reason  often  given  for  expecting  wages  to 
be  different  from  what  they  would  need  to  be  to  express  the  mar- 
ginal significance  of  labor,  is  that  wages  in  many  fields  are  fixed  by 
custom.  Thus  we  have  been  wont  for  years  to  pay  housemaids  $3 


XL]  WAGES  483 

to  $4  per  week  in  one  social  class,  $5  to  $6  in  another,  $7  to  $10  in 
another.  Similarly,  the  wages  of  common  labor  range  usually  from 
$i  to  $1.50  per  day.  Now,  without  doubt,  custom  has  some  direct 
influence  on  the  rate  of  wages;  but  that  influence  is,  in  the  opinion 
of  the  writer,  much  exaggerated.  In  the  first  place,  the  facts  do  not 
display  the  degree  of  uniformity  claimed.  Within  a  few  years  a 
very  marked  change  in  the  alleged  customary  standard  has  taken 
place.  The  amount  which  we  commonly  assume  will  have  to  be 
paid  for  one  or  another  type  of  labor  has  changed  three  or  four 
times  in  the  memory  of  living  men.  Again,  the  uniformity  claimed 
is  not  exact  enough  to  show  the  effect  of  custom.  Custom  is  nothing 
if  not  fairly  inelastic.  A  custom  which  permitted  men  to  wear  at  a 
formal  dinner  anything  from  a  frock  coat  to  a  doctor's  gown  would 
not  be  called  a  custom  at  all.  So,  a  custom  which  makes  wages  for 
one  type  of  service  range  from  $3  to  $4  a  week  can  hardly  be  called 
a  custom. 

Again,  if  wages  were  so  much  under  the  influence  of  custom, 
we  should  see  but  little  change  in  their  rate  due  to  inflation  of  the 
currency,  rise  in  the  value  of  the  standard,  immigration,  booms  in 
business,  and  other  modifying  conditions.  But  statistical  investiga- 
tions have  shown  that  wages,  though  moving  somewhat  slowly,  do 
actually  move  in  response  to  changed  conditions.  Finally,  the  con- 
siderations noted  a  few  paragraphs  back,  publicity,  general  educa- 
tion and  universal  initiative,  create  a  strong  presumption  against 
the  belief  that  in  our  day  mere  custom  can  exert  a  marked  influence 
in  wage-determination. 

Bargaining. — We  have,  finally,  to  remark  a  tendency  rather 
pronounced  with  some  present-day  writers  to  put  forward  the  in- 
fluence of  bargaining  in  the  determining  of  wages  as  a  reason  why 
wages  cannot,  and  do  not,  express  marginal  significance.  These 
writers  usually  set  out  with  the  idea  that  the  sole  downward  limit 
of  wages  is  what  the  laborer  will  take,  much  as  the  upper  limit  is 
what  the  employer  can  afford  to  pay.  They  thus  overlook  altogether 
the  part  played  by  employers  in  fixing  another  possible  lower  limit 
to  wages,  and  hence  insure  that  the  supposed  lower  limit  shall  be  a 
very  low  one  indeed,  one  leaving  ample  room  for  bargaining.  But 


484  PRINCIPLES  OF  ECONOMICS  [XL 

this  analysis  is  certainly  unsound.  There  is  another  lower  limit 3 
besides  what  the  laborer  will  take,  namely,  the  significance  of  labor 
to  the  first  extra-marginal  employer;  and  this  limit  is  often  much 
higher  than  the  employee's  minimum,  so  that  the  range  of  bargaining 
is  much  narrowed.  Further,  a  good  deal  could  be  said  for  the  con- 
tention that  the  laborer's  minimum  which  really  appears  most  of  the 
time  is  the  wage  he  believes  he  can  get  elsewhere ;  it  is  not  a  true 
laborer's  minimum  but  rather  a  minimum  set  by  the  extra-marginal 
employer. 

Generally  speaking,  then,  bargaining  does  not  seem  to  act  upon 
wages  with  the  force  recently  attributed  to  it,  and  does  not  seem  to 
limit  in  any  marked  degree  the  dominance  of  the  principle  of  mar- 
ginal significance.  In  so  far  as  our  principle  is  displaced  by  bargain- 
ing, this  is  probably  true,  not  because  bargaining  as  such  can  override 
the  natural  limits  set  by  the  marginal  and  first  extra-marginal  signifi- 
cances, but  because  the  bargaining  is,  on  one  side,  collective,  monopo- 
listic. The  individual  employer  has  to  deal,  not  with  each  workman, 
nor  even  with  his  workmen  as  a  unit,  but  with  the  trade ;  and  the 
trade  as  a  totality  has  restricted  competition  in  one  way  and  another 
so  that  bargaining  can  move  wages  outside  the  limits  set  by  the 
marginal  and  extra-marginal  significances  of  the  natural  output. 
But  this  was  already  provided  for  in  admitting  that  monopolistic 
labor  could  set  limits  other  than  those  which  would  be  established  by 
the  marginal  significance  of  the  natural  output. 

II 
Wages  and  Disutility 

Overtime  Labor. — An  interesting  confirmation  of  the  con- 
tention that  wages  have  to  be  such  as  to  express  the  marginal  dis- 
utility of  supplying  labor  services,  is  to  be  found  in  the  fact  that 
everywhere  laborers  insist  on  higher  rates  of  compensation  for 
overtime  work.  The  disutility  attaching  to  an  eleventh  or  twelfth 
hour  of  labor  is  greater  than  that  attaching  to  the  earlier  hours,  and 


"Oddly  enough,  the  analysis  is  usually  inconsistent  at  this  point;  for  it 
does  not  ignore  the  part  played  by  employees  in  fixing  an  upper  limit  which 
may  be  under  that  fixed  by  employers. 


XLJ  WAGES  485 

employers   commonly  find  it  necessary  to  offer  higher  rates   for 
these  extra  hours  to  induce  the  desired  supply  of  labor. 

Freedom  of  Action  Lacking. — It  is  sometimes  objected,  in 
this  connection,  however,  that  the  laborer's  freedom  of  action  is  too 
limited,  under  modern  conditions,  to  make  possible  the  easy  opera- 
tion of  the  disutility  half  of  our  principle.  Under  a  simpler  order 
of  things  the  laborer  might  cease  working  as  soon  as  the  added 
utility,  in  the  form  of  wages  or  goods,  fell  below  the  marginal  dis- 
utility of  his  labor.  He  would  stop  his  day's  work  at  the  end  of 
say  ten  hours,  or  nine,  or  eight,  unless  an  additional  hour  would 
clearly  add  enough  to  his  returns  to  offset  his  discomfort.  But  un- 
der modern  conditions  the  length  of  the  day  is  largely  a  fixity,  de- 
termined by  custom  and  by  the  necessities  of  business  processes. 
The  latter  commonly  require  the  coordinated  working  of  great 
numbers  of  persons  and  large  volumes  of  capital.  The  individual 
laborer  cannot  decide  of  his  own  motion  to  shorten  his  day  to 
nine  hours  or  eight  hours,  for  he  is  only  a  small  part  of  a  vast  and 
complicated  mechanism.  This  shortening  of  the  day  can  only  be 
done  concert edly  by  the  common  consent  of  many  employees  and 
employers. 

Still  Much  Freedom. — This  objection  is  not  without  point, 
yet  it  has  much  less  weight  than  one  might  suppose  at  first  sight. 
The  disutility  of  labor  can  act  upon  the  supply  and  so  upon  the  price 
of  labor,  not  only  by  altering  the  length  of  the  working  day,  but 
also  by  diminishing  the  total  number  of  working  days  and  the 
total  number  of  men  who  work  at  all.  The  decrease  in  the  number 
of  working  days,  as  a  result  of  disutility,  is  especially  conspicuous 
in  times  when  the  demand  for  labor  is  very  great  and  wages  conse- 
quently very  high ;  but  at  all  times  it  probably  plays  a  greater  part 
than  is  commonly  supposed.  A  very  considerable  per  cent  of  the 
men  who  are  engaged  in  the  ordinary  trades  which  we  have  in  mind 
when  speaking  of  labor  in  general,  work  a  few  days,  weeks,  or 
months,  and  then  loaf  for  a  time,  not  hesitating  even  to  give  up  the 
present  job,  confident  in  the  knowledge  that  they  can  easily  find 
another. 


486  PRINCIPLES  OF  ECONOMICS  [XL 

Only  Freedom  at  the  Margin  Needed. — Doubtless  the  num- 
ber of  men  who  are  ready  to  quit  work  altogether  and  thus  reduce 
the  supply  of  labor,  when  wages  are  inadequate  to  cover  the  dis- 
utility as  rated  by  them,  is  smaller  than  the  number  who  quit  work 
temporarily.  Men  are  more  loath  to  become  dependent  upon  rela- 
tives, or  "take  to  the  road."  But  this  number  is  not,  after  all,  neg- 
ligible. It  helps  to  give  the  labor  supply  an  elasticity  sufficient  to 
make  disutility  a  real  factor  in  the  determination  of  wages.  For 
we  must  remember  that  it  is  not  necessary  that  all  or  a  very  large 
part  of  the  supply  should  be  ready  to  drop  out — it  is  sufficient  that 
an  appreciable  margin  should  be  in  this  attitude. 

Wages  and  the  Standard  of  Living. — The  effect  of  disutility 
on  the  supply  of  labor,  and  hence  on  wages,  is  brought  about  not 
merely  by  a  decrease  in  the  supply  of  labor  services  from  men  and 
women  already  living,  but  it  is  reflected  also  in  the  size  of  laboring 
men's  families,  and,  so,  in  the  future  supply  of  labor.  While  there 
is  probably  little  direct  regulation  of  the  size  of  workingmen's  fam- 
ilies because  of  economic  motives,  yet,  through  both  conscious  and 
unconscious  processes,  population  tends  so  to  adjust  itself  that  the 
typical  rate  of  wages  is  compelled  to  coincide  roughly  with  the  work- 
ingman's  conception  of  what  is  essential  to  a  decent  living.  This, 
of  course,  means  merely  that  the  result  named  is  effected  in  the  long 
run.  Laborers  cannot  raise  their  wages  here  and  now  merely  by 
deciding  that  more  is  needed  to  insure  a  decent  living.  At  any  mo- 
ment their  numbers  are  fixed ;  and  comparatively  few  will  take  to 
the  road  for  the  difference  between  $1.50  and  $1.40  a  day.  Their 
wages,  therefore,  must  for  the  moment  roughly  correspond  to  the 
marginal  significance  of  their  labor.  But  a  given  standard  of  living 
insisted  upon  through  a  series  of  years  will  express  itself  in  dimin- 
ished population ;  this,  in  the  end,  will  raise  the  marginal  significance 
of  lalor ;  which,  finally,  will  raise  wages  to  the  required  height. 

A  very  practical  application  of  the  above  principle  is  seen  in 
the  fact  that  the  rate  of  wages  can  be  altered  by  changing  the  ideals 
of  the  wage-earners.  Adverse  conditions  may  permanently  lower 
actual  wages,  because  those  adverse  conditions  may  hold  wages  be- 
low the  old  standard  of  living  until  the  working  classes  have  in- 


XL]  WAGES  487 

sensibly  come  to  accept  a  new  inferior  standard.  On  the  other 
hand,  favorable  circumstances  may  work  the  opposite  result.  In 
short,  a  new  level  of  wages  brought  about,  and  for  some  time  main- 
tained, by  temporary  causes,  tends  to  persist. 

The  points  brought  out  above  may  be  formulated  in  the  follow- 
ing principle  and  corollary. 

Principle.  Under  the  natural  working  of  economic  and 
social  forces,  the  long-run  rate  of  wages  tends  to  be  that 
rate  which  will  enable  the  working  classes  to  maintain 
that  standard  of  living  which,  in  the  particular  time  and 
place,  is  looked  on  as  necessary  to  a  decent  living. 

Corollary.  In  the  long  run  the  rate  of  wages  can  be 
altered  by  changing  the  ideals  of  the  working  classes  as  to 
what  is  essential  to  a  decent  living. 

ILLUSTRATIVE  PROBLEMS 

1.  What  bearing  does  our  principle  have  on  the  question  whether 
Chinese  immigration  should,  or  should  not,  be  discouraged? 

2.  "No  remedies  for  low  wages  have  the  smallest  chance  of  being 
efficacious,  which  do  not  operate  on  and  through  the  minds  and  habits  of 
the  people." — Mill. 

Argue  for  the  truth  of  this  statement.  (It  probably  needs  qualifica- 
tion; but  leave  that  for  some  other  occasion.) 

3.  Argue   that,   though   the   restrictive   policy  in  the  trades  unions 
temporarily  injures  lower  classes  of  workingmen,  in  the  long  run  it  is 
likely  to  raise  wages  generally. 

Ill 
The  Theory  of  Employment 

Employment  and  Say's  Law. — One  aspect  of  the  wages 
problem  which  has  the  greatest  practical  importance  for  every 
worker  is  employment.  Some  of  the  most  important  aspects  of 
this  matter  connect  themselves  with  a  topic  discussed  much  earlier 
in  this  text  under  the  title  of  Say's  Law.  In  our  present  connection, 


488  PRINCIPLES  OF  ECONOMICS  [XL 

we  will  merely  enumerate  some  of  the  corollaries  of  that  law  apply- 
ing to  employment. 

1 i )  The  destruction  of  objects  of  wealth  which  are  bound  to  be 
replaced  does  not  increase  employment. 

(2)  Private  expenditure  for  extravagances,  as  contrasted  with 
other  forms  of  expenditure  or  even  with  hoarding,  does  not  increase 
employment. 

(3)  Governmental  extravagance  does  not  increase  employment. 

(4)  Producing  for  oneself,  when  it  is  done  without  decreasing 
one's  output  for  the  market,  does  not  diminish  employment. 

It  might  be  well,  perhaps,  to  give  this  last  proposition  the  benefit 
of  an  illustration.  A  person  who  produces  through  his  property 
or  his  efforts,  say,  $1,000  worth  of  products  each  year,  does  not 
diminish  employment  by  putting  in  some  spare  time  building 
himself  a  rowboat.  Assuming  that  his  outside  production  is  not 
changed,  his  demand  for  goods  on  the  market  is  the  same  as 
before,  and  therefore  creates  the  same  volume  of  employment 
opportunities.  . 

(5)  Broadly  speaking,  an  increase  in  the  supply  of  labor  services 
creates  opportunities  for  employment  as  well  as  absorbing  them, 
though  not  usually  in  quite  the  same  proportion. 

This  proposition  is  not  so  evident  as  the  preceding ;  nor  can  it  be 
accepted  without  larger  qualifications.  But  it  is  still  substantially 
true.  If  the  whole  producing  group  creates  a  demand  for  labor  by 
producing,  it  follows  that  the  labor  part  of  the  producing  group  cre- 
ates a  demand  for  labor  by  its  producing.  Doubtless  it  must  be  ad- 
mitted that  not  all  the  demand  created  by  labor's  production  will 
eventuate  in  a  demand  for  other  labor;  since  labor's  demand  for 
goods  will  be  a  demand  for  all  the  factors  necessary  to  produce 
those  goods,  land  and  capital  services,  as  well  as  labor  services.  But 
with  the  majority  of  commodities,  the  contribution  of  labor,  direct 
or  indirect,  is  by  all  odds  the  most  important  element. 

There  is  no  intention  here  of  asserting  that  the  process  described 
will  have  no  adverse  effect.  Without  doubt  it  will  tend  to  cause 
some  decline  in  the  rate  of  wages,  under  the  working  of  the  principle 
of  diminishing  marginal  significance.  But  this  result  is  not  to  be 
confused  with  the  question  of  employment. 


XL]  WAGES  489 

Employment  and  Foreign  Trade. — One  of  the  most  obstinate 
of  popular  fallacies  is  the  notion  that  the  employment  opportunities 
of  the  people  of  a  community  are  diminished  by  carrying  on  trade 
with  other  communities,  that  buying  outside  takes  away  jobs  from 
one's  own  people.  The  unsoundness  of  this  notion  was  brought  out 
in  the  chapter  on  the  Principle  of  Reciprocity.  In  this  connection, 
therefore,  only  a  word  is  needed.  Foreign  trade  is  necessarily  re- 
ciprocal. If  we  are  buying  abroad,  we  must  be  selling  abroad, — 
must  be  delivering  the  foreigner  some  form  of  wealth,  either  goods 
or  money. 

But,  in  producing  the  commodity  or  commodities  with  which 
we  pay  the  foreigner  for  our  purchases,  we  create  opportuni- 
ties for  employment  just  as  truly  as  we  should  by  producing  the 
imported  goods  at  home.  There  are  some  valid  arguments  for  arti- 
ficially developing  certain  industries  within  our  own  borders ;  but 
this  "more  employment"  argument  is  not  one  of  them. 

Employment  Dependent  on  Land  and  Capital. — In  carrying 
forward  the  preceding  discussion,  it  was  assumed  that,  in  demanding 
goods,  the  public  create  an  almost  equal  demand  for  labor,  and,  so 
create  an  almost  equal  amount  of  employment.  But  this  presents 
only  a  partial  view  of  the  matter,  since  production  requires  other 
factors  besides  labor.  A  demand  for  goods  cannot  constitute  a  de- 
mand for  the  labor  needed  to  produce  those  goods,  unless  there  are 
land  and  capital  available  to  complete  the  combination.  It  is,  of 
course,  equally  true  that  a  demand  for  goods  does  not  constitute  a 
demand  for  the  land  necessary  to  produce  those  goods,  unless  there 
are  available  labor  and  capital  to  complete  the  combination ;  and  a 
similar  affirmation  may  be  made  with  respect  to  capital.  In  short, 
in  a  sense  each  kind  of  productive  goods  constitutes  a  demand  for 
the  others.  Our  concern  here,  however,  is  with  the  opportunities  of 
labor  rather  than  land  or  capital.  A  formal  statement  of  the  point 
just  made  gives  us  the  following: 

Principle.  Broadly  speaking,  satisfactory  -opportuni- 
ties for  employment  vary  with  the  abundance  of  natural 
resources  and  capital. 


490  PRINCIPLES  OF  ECONOMICS  [XL 

Limits  of  Possible  Employment. — In  the  preceding  discus- 
sion we  affirmed  the  reciprocal  dependence  of  land,  capital,  and  labor 
for  opportunity.  Rigidly  interpreted,  this  doctrine  would  suggest 
that  there  is  a  definite  limit  to  the  opportunities  for  each  of  these 
factors,  or,  for  our  special  purpose,  to  those  of  labor.  Given  a 
certain  outfit  of  natural  resources  and  capital,  there  will  be  oppor- 
tunity to  utilize  a  definite  amount  of  labor  and  no  more.  Such  an 
interpretation  would  nicely  support  the  popular  notion  that  there  are 
just  so  many  jobs,  no  more  and  no  less,  so  that  giving  a  job  to  one 
person  necessarily  takes  one  from  somebody  else.  To  the  trained 
economist,  this  view  seems  quite  unwarranted.  But  possibly  our 
present  discussion  may  have  given  it  some  color  of  sense.  Does  not 
the  affirmation  that  land  and  capital,  as  well  as  labor,  are  essential 
to  production  support  the  contention  that  labor  opportunities  are 
strictly  limited? 

In  answering  this,  we  have  to  remind  ourselves  that  all  industry 
is,  during  some  period,  in  the  condition  of  returns  increasable  at 
diminishing  rate.  That  is,  even  if  the  available  quantities  of  land 
and  capital  are  constant,  yet  increasing  the  amount  of  labor  will  in- 
crease the  total  return  to  the  combination,  though  not  proportion- 
ately. Since  the  increase  in  return  is  the  contribution  in  the  product 
which  will  be  credited  to  the  additional  labor,  and,  as  such  contribu- 
tions will  determine  the  price  of  labor,  it  follows  that  the  new 
conditions  will  lower  wages.  Still,  this  will  not  alter  the  fact  that 
the  new  labor  has  found  employment.  Accordingly,  we  may  say  that, 
under  ordinary  conditions,  no  one  need  lack  employment  if  he  is 
content  to  accept  that  wage  which  expresses  the  new  marginal  pro- 
ductivity of  labor. 

As  a  basis  for  th6  foregoing  argument,  it  was  said  that,  during 
some  period,  industry  is  in  the  condition  of  returns  increasable  at 
diminishing  rate.  But  this  basis  does  not  always  hold,  and  so  the 
principle  laid  down  calls  for  qualification.  It  is  possible  that  in- 
dustry should  reach  a  stage  where  its  returns  are  substantially  fixed, 
where  they  have  reached  their  maximum  ; — even  if  the  efforts  of  an- 
other laborer  could  increase  the  output  somewhat,  still  the  additional 
amount  would  be  so  small  that  even  with  the  extremest  conceivable 
economy  it  would  not  furnish  subsistence.  '  Employment  is  so  far 


XL]  WAGES 


491 


dependent  on  land  and  capital,  and  the  possibilities  of  industry  are 
so  limited  that  a  time  is  always  liable  to  come  when  opportunities 
for  employment  cannot  experience  any  measurable  increase,  when 
no  more  laborers  can  be  utilized. 

Further,  in  actual  life  the  practical,  effective  limit  to  employment 
is  usually  reached  somewhat  short  of  the  combination  of  maximum 
returns.  The  decline  in  the  marginal  productivity  of  labor  does  not 
go  on  till  men  could  live  on  no  less.  Rather  it  stops  where  they  will 
live  on  no  less.  In  earlier  times  conquering  migration  and,  more 
recently,  peaceful  emigration  have  brought  relief ;  and  in  our  own 
day  improvements  in  methods  of  production  have  repeatedly  pushed 
far  into  the  distance  the  point  of  maximum  returns. 

Employment  and  the  Rivalry  of  Capital. — We  have  seen  that 
in  some  sense  and  to  some  degree  employment  opportunities  are  de- 
pendent on  the  presence  of  a  large  volume  of  capital.  It  has  to  be 
added  that  the  fulfilment  of  this  condition  may  also  bring  an  un- 
favorable reaction.  Capitalistic  methods  are  generally  labor-saving 
methods,  hence  methods  which  in  themselves  decrease  the  need  for 
labor  as  compared  with  the  need  for  capital.  Capital  therefore  ap- 
pears in  some  sense  the  rival  or  competitor  of  labor.  This  fact  has 
naturally  given  rise  to  much  controversy  as  to  whether  the  intro- 
duction of  improved  methods  does  not  diminish  the  total  demand 
for  labor.  ( i )  All  are  agreed  that  immediately  certain  classes  of 
laborers  suffer  by  being  thrown  out  of  employment  and  compelled 
to  make  new  adjustments.  (2)  Experience  shows  that,  in  any  given 
industry  taken  as  a  whole,  there  is  little,  if  any,  decrease  in  employ- 
ment ;  because  the  lowered  price  due  to  lowered  cost  so  stimulates 
demand  that  the  old  workers  are  needed  to  meet  that  demand  even 
under  the  new  and  more  efficient  methods.  (3)  The  lowered  price 
due  to  lowered  cost,  if  it  does  not  create  new  demand,  releases 
buying  power  saved  because  of  the  lower  price,  which  will  be  spent 
on  new  products,  save  on  the  almost  inconceivable  hypothesis  that 
goods  have  become  so  abundant  and  their  marginal  utility  so  low 
that  people  no  longer  want  more  things.  But  supplying  these  new 
products  will  furnish  employment  opportunities  for  the  labor  dis- 
placed in  the  old  industries. 


492  PRINCIPLES  OF  ECONOMICS  [XL 

These  last  remarks  would  not  show  that  the  introduction  of 
improvements  has  no  tendency  to  lower  wages  by  making  labor 
relatively  more  abundant  and  so  lowering  its  marginal  utility.  We 
are  here  concerned  only  with  opportunities  for  employment  at  some 
wage  or  other. 


CHAPTER  XLI 

PROFITS 

I 
The  Real  Nature  of  Profits 

In  the  business  world,  profits  were  early  recognized  as  a  special 
share  in  distribution,  though  sharply  distinguished  from  interest  only 
when  part  of  the  capital  was  borrowed.  This  recognition  was  present 
also  in  the  earlier  theoretic  discussions.  The  medieval  churchmen, 
who  sweepingly  condemned  interest — usury  as  they  called  it — seem 
to  have  considered  profits  legitimate,  meaning  by  profits  a  share 
going  to  the  capitalist  who  undertook  the  risks  of  enterprise.  But, 
after  economics  had  come  to  have  some  scientific  development, 
profits  largely  failed,  especially  among  the  English  and  American 
writers,  to  receive  any  distinct  and  separate  treatment. 

Even  when  in  the  middle  of  the  last  century  the  office  of  the 
entrepreneur  began  to  get  attention  from  English  economists,  there 
was  a  singular  failure  to  recognize  his  true  function.  He  was  rep- 
resented as  primarily  the  man  who  managed  productive  operations. 
And  this  happened  in  countries  in  which  industry  was  rapidly  pass- 
ing into  the  hands  of  entrepreneurs  who  hired  men  to  manage  their 
business  rather  than  doing  it  themselves.  This  doctrine  still  shows 
a  most  astounding  tenacity  in  the  texts,  though  it  is  manifestly  quite 
untenable.  The  peculiar  function  of  the  entrepreneur  must  surely 
be  found  in  something  which  he  only  can  do,  which  he  cannot  hire 
someone  else  to  do.  For  anything  coming  under  the  latter  category 
is  plainly  labor.  Now,  the  only  functions  which  seem  necessarily 
to  be  left  with  the  entrepreneur,  are  the  assuming  of  final  responsi- 
bility and  performing  certain  types  of  management  which  cannot  be 
delegated,  for  example,  appointing  those  who  shall  direct  the 
business. 

493 


494  PRINCIPLES  OF  ECONOMICS  [XLI 

Gross  Profits. — Profits,  as  the  term  is  frequently  used  by  the 
general  public,  include  the  whole  net  return  to  the  responsible  owner 
of  a  business  after  money  outlay  has  been  deducted  from  money 
receipts.  This  whole  return,  which  we  might  call  gross  profits, 
usually  includes  at  least  three  elements,  (i)  wages  of  some  sort, 
principally  for  management,  (2)  interest  on  capital  invested,  and 
(3)  a  remuneration  for  taking  the  responsibility  of  production,  and 
making  certain  -final  decisions  which  necessarily  fall  to  the  owner. 

The  first  element  has  come  to  be  eliminated  from  profits  even  in 
the  popular  sense  of  the  term  because  of  the  great  extension  of  the 
corporate  form  of  business  in  which  the  work  of  management  is 
turned  over  to  hired  officials.  The  second  element,  interest,  is  still 
commonly  included.  That  is,  stockholders  in  a  concern  paying  7  per 
cent  dividends  would  think  of  the  business  as  yielding  7  per  cent 
profit,  rather  than  4  per  cent  interest  plus  3  per  cent  profit.  In  this 
sense,  profit  is  contrasted  with  interest  in  being  the  return  to  the 
capitalist  who  bears  the  whole  burden  of  ownership,  waiting  plus 
responsibility-taking;  while  interest  is  the  return  to  the  capitalist 
who  assumes  only  one  part  of  the  burden,  waiting.  In  strict  eco- 
nomic analysis,  however,  profits  ought  to  be  limited  to  the  third 
element,  the  taking  of  responsibility  and  making  final  decisions. 
From  this  point  of  view,  profits  in  the  illustration  above  would  be 
only  3  per  cent,  the  difference  between  what  the  capital  would  have 
received  if  lent  to  the  company  and  what  it  actually  did  receive  as 
invested  in  the  business.  Profits  in  this  sense,  we  will  call  pure 
profits  or  profits  proper. 

Pure  Profits. — Pure  profits,  then,  are  the  remuneration  for 
responsibility-taking,  especially  for  the  risk  element  in  responsibility- 
taking.  They  include  an  infinitesimal  amount  of  wages,  in  that  the 
owner  must  make  certain  final  decisions — though  in  practice  this 
tends  to  become  negligible — and  perhaps  other  disutilities  or  sacri- 
fices. But  the  chief  element  in  the  case  is  the  bearing  of  economic 
risk. 

Profits  Risk  a  Special  Type. — That  risk  for  the  bearing  of 
which  profits  are  paid  must  not  be  confused  with  the  regularly  re- 


XLI]  PROFITS 


495 


citrring,  calculable  losses  of  a  business.  Such  losses  simply  increase 
the  outlay  for  labor  and  capital  goods.  The  remuneration  received 
by  the  entrepreneur  because  of  such  losses  would  never  be  thought 
of  as  profits,  but  only  as  a  fund  to  replace  costs.  The  risk  for  which 
profits  are  paid  is  the  risk  of  losses  which  cannot  be  recouped  in  the 
experience  of  the  individual  entrepreneur, — risks  of  total  failure, 
or  some  loss  almost  as  great.  Compare  the  breakage  of  bottles  in  the 
brewery  business  with  the  chance  that  temperance  legislation  will 
destroy  the  business.  The  former  is  covered  by  greater  outlay.  The 
latter  is  a  not-to-be-compensated  loss.  To  induce  men  to  assume 
the  risk  of  such  a  loss,  they  must  be  paid  something,  not  of  course 
enough  to  cover  the  loss  if  the  risk  should  become  a  certainty,  but 
enough  to  move  their  wills  to  face  the  possibility  of  loss.  It  is  thus 
evident  that  profits  must  not  be  conceived  as  a  contribution  to  an 
insurance  fund  from  which  losses  are  covered.  There  is  no  such 
fund;  the  losses  are  not  covered. 

Profits  Under  Socialism. — Under  Socialism,  /the  sort  of  risk 
now  remunerated  by  profits  would  in  the  main  be  covered  by  an  in- 
surance fund ;  since  the  state,  having  a  complete  monopoly  of  pro- 
duction, would  pool  in  its  own  hands  all  risks,  and,  as  well,  all 
chances  of  occasional  gain.  The  risk  cost  of  production,  therefore, 
except  perhaps  in  the  case  of  long-time  enterprises  undertaken  for 
future  generations,  would  become  simply  more  capital  and  labor  cost, 
instead  of  being  as  now,  the  price  of  the  psychological  disutility  of 
bearing  risks.  It  is  probable  that  the  state  would  charge  each  com- 
modity with  the  average  cost  of  the  whole  output  of  that  commodity, 
including  successful  and  unsuccessful  branches  of  the  industry  in- 
volved. Profits,  as  an  element  of  cost,  would  not  therefore  be 
entirely  eliminated  under  socialism,  but  would  appear  in  another 
guise. 

II 

Do  Profits  Tend  to  Disappear? 

A  noteworthy  fact  in  recent  economic  discussion  is  a  disposition 
to  hold  that  profits — pure  profits — tend  to  disappear.  The  argument 
for  this  contention  moves  along  two  general  lines,  (i)  It  is  affirmed 


496  PRINCIPLES  OF  ECONOMICS  [XLI 

that  pure  profits,  assuming  them  to  be  paid  for  risk-taking,  will 
necessarily  disappear  with  the  elimination  of  risk  from  industrial 
affairs ;  and  such  elimination  is  steadily  proceeding  through  the  in- 
crease of  knowledge,  forethought,  and  invention.  (2)  Secondly, 
it  is  claimed  that  the  disutilities  correlated  to  profits  are  disutilities 
which  plenty  of  men,  especially  in  America,  are  quite  willing  to 
assume  without  reference  to  an  economic  reward.  The  desire  for 
power,  the  craving  for  better  social  standing,  and  the  gambling  spirit 
which  eagerly  improves  the  opportunity  to  take  chances, — all  these 
unite  to  make  men  willing  to  undertake  the  responsibilities  of  pro- 
duction, even  though  they  expect  to  get  nothing  more  than  ordinary 
interest  on  their  capital  and  ordinary  wages  for  their  labor. 

Chance  Not  to  Disappear. — In  reply  to  the  first  of  these 
arguments,  it  seems  sufficient  to  declare  that  the  complete  disap- 
pearance of  risk,  chance,  uncertainty  from  industrial  affairs,  if  not 
quite  impossible,  is  certainly  so  remote  that  it  cannot  properly  be 
made  the  basis  for  any  affirmations  with  respect  to  the  present  order. 
Some  centuries  hence  we  may  have  become  able  to  predict  the 
weather  for  a  year  in  advance  with  absolute  precision ;  but  we  shall 
still  have  to  reckon  with  the  uncertainties  due  to  human  folly  and 
caprice. 

Motives  Named  Inadequate. — The  second  argument  is  less 
easy  to  answer,  yet  will  not,  I  think,  carry  conviction  to  most  persons. 
The  first  two  motives  named,  the  desire  for  power  and  the  desire 
for  social  position,  affect  only  a  small  minority  of  our  entrepreneur 
class,  namely,  the  small  individual  or  partnership  entrepreneurs,  who 
combine  in  themselves  the  functions  of  capitalist,  manager,  and 
entrepreneur.  For  most  of  our  entrepreneurs,  belonging  to  that  class 
merely  by  virtue  of  being  stockholders  in  some  industry  organized 
as  a  corporation,  enjoy  neither  power  nor  prestige.  Under  the 
corporate  organization  of  industry,  salaried  officials  are  the  ones 
who  wield  power  and  the  social  position  of  capitalists  (bond-holders) 
is  surely  as  good  as  that  of  stockholders,  assuming  their  investments 
to  be  equal.  But,  if  there  is  any  large  section  of  the  entrepreneur 
class  with  whom  these  non-economic  motives  would  not  suffice, — 


XL1]  PROFITS  497 

who  would  insist  on  a  greater  economic  return  for  taking  responsi- 
bility than  for  simply  lending  their  capital — then,  profits  would 
surely  have  to  be  paid. 

Pure  Risk  Not  Desired. — The  third  consideration, — the 
gambler's  desire  to  take  risks — contains  the  old  confusion  of  ideas 
which  has  already  been  commented  on  more  than  once.  It  is  un- 
doubtedly true  that  men  are  so  ready  to  take  risks,  when  a  possible 
prize  is  in  sight,  that  they  do  not  as  a  whole  class  have  to  be  remu- 
nerated for  taking  that  risk.  If  all  the  copper  producers  of  the 
world  spend  500  million  dollars  worth  of  labor  and  capital  getting 
out  the  product,  it  is  not  necessary  that  the  product  should  be  worth 
500  millions  plus  something  for  the  risks  taken.  On  the  contrary, 
that  product  will  probably  be  worth  less  than  its  labor  and  capital 
cost,  say  400  millions.  But  all  this  is  beside  the  point.  The  real 
issue  concerns,  not  the  whole  class  of  entrepreneurs  interested,  but 
only  those  upon  whose  conduct  depends  the  output  actually  supplied, 
the  successful  entrepreneurs.  Do  these  persons  have  to  get  profits? 
Surely  they  do,  else  there  would  not  be  this  gambler's  eagerness  to 
assume  the  risks  of  the  business.  The  proper  test  for  determining 
whether  profits  as  a  remuneration  for  risk-taking  really  exist,  is  this : 
Does  society  have  to  pay  a  higher  price  for  a  given  commodity  or 
service  than  it  would  have  to  pay  if  risk  were  eliminated  ?  Surely 
there  can  be  but  one  answer  to  that  question,  the  affirmative  one. 

Ill 
Profits  as  Affected  by  Changes  in  the  Value  of  Money 

In  an  earlier  discussion,  it  was  shown  that  the  value  of  money 
itself  may  change,  and  so  general  changes  in  prices  may  take  place 
without  reference  to  the  conditions  ordinarily  governing  the  value 
of  each  commodity.  Thus,  under  the  paper  money  standard  of 
Civil  War  times,  there  was  a  general  rise  of  prices,  or,  in  other 
words,  a  fall  in  the  value  of  money,  in  the  United  States.  So,  for 
many  years  following  1873  there  was  a  general,  though  gradual,  fall 
in  prices, — a  rise  in  the  value  of  money, — affecting  most  or  all  of 
the  western  nations.  Much  more  rapid  ups  and  downs  mark  the 


498  PRINCIPLES  OF  ECONOMICS  [XLI 

periods  immediately  preceding  or  following  commercial  crises  or 
panics. 

Common  Fallacy. — There  has  naturally  been  much  debate 
as  to  how  far  such  movements  influence  all  shares  in  distribution  and 
particularly  profits.  At  first  thought  one  is  inclined  to  say  that  of 
course  such  changes  influence  profits.  If  a  merchant  has  paid 
$100,000  for  a  stock  of  goods  and  because  of  a  universal  and  simul- 
taneous fall  in  prices,  their  value  declines  to  $60,000,  how  can  anyone 
deny  that  the  merchant  is  losing  $40,000?  This  sounds  plausible, 
but  is  in  fact  an  undoubted  fallacy.  A  universal  and  simultaneous 
fall  in  prices  of  40  per  cent  raises  the  buying  power  of  $60,000  till 
it  is  just  as  great  as  was  the  value  of  $100,000.  Assuming,  then, 
that  no  other  element  was  involved,  the  merchant  in  question  would 
neither  gain  nor  lose  as  a  result  of  the  general  fall  in  prices.  That 
fall  in  prices  does  not  of  itself  mean  a  fall  in  profits. 

Borrowed  Capital. — The  above  affirmation  was  qualified  by 
the  assumption  that  no  other  element  was  involved.  But  in  actual 
life  this  condition  is  seldom  fulfilled.  In  the  first  place,  the  merchant 
is  usually  carrying  on  his  business  in  greater  or  smaller  measure 
with  borrowed  capital.  But  the  sum  which  he  has  promised  to  pay 
when  borrowing  does  not  change  because  the  value  of  money  has 
changed.  If  he  is  using  $20,000  of  borrowed  capital,  he  will  have  to 
pay  back,  not  three-fifths  of  that  sum — $12,000 — but  the  whole 
$20,000.  His  debt  has  not  shrunk  though  the  value  of  his  goods  has. 
To  pay  his  debt  he  will  need  so  much  of  his  goods  as  are  now  worth 
$20,000,  which  means  so  much  of  those  goods  as  were  worth  five- 
thirds  of  $20,000,  or  $33,000.  Hence  he  has  lost  the  difference  be- 
tween $20,000  and  $33,000,  or  $13,000.  It  follows  that,  in  so  far  as 
the  dealer  works  upon  borrowed  capital,  a  change  in  the  value  of 
money  causes  an  inverse  change  in  his  profits :  If  the  value  of  money 
rises  he  loses  proportionately,  and  if  that  value  falls  he  gains  pro- 
portionately. 

Unequal  Rate  of  Price  Changes. — Another  element  in  this 
situation  which  compels  a  qualification  of  our  original  statement  is 


XLI]  PROFITS  499 

that  general  price  movements  do  not  take  place  at  an  equal  rate  all 
along  the  line.  Some  goods  rise  or  fall  more  rapidly  and  more 
promptly  than  others.  In  particular,  wages  do  not  change  as  rapidly 
as  general  goods.  It  follows  that  a  rise  in  prices, — a  fall  in  the 
value  of  money — is  likely  to  redound  to  the  advantage  of  the  dealer, 
in  that  he  gets  a  larger  return  from  the  sale  of  his  goods  while  his 
expenses  for  labor  have  not  proportionately  increased.  And  of 
course  a  reversal  of  the  situation,  that  is,  a  general  fall  in  prices, 
an  increase  in  the  value  of  money,  works  to  the  disadvantage  of  the 
dealer  for  precisely  opposite  reasons. 

IV 
Profits  and  the  Significance-Disutility  Principle 

The  attempt  to  establish  the  validity  of  our  significance-disutility 
principle  for  each  of  the  economic  shares  meets  the  greatest  difficulty 
in  the  case  of  profits.  As  already  explained,  we  mean  by  profits 
proper  the  return  going  to  the  man  who  takes  the  responsibility  of 
ownership.  We  usually  distinguish  several  different  sorts,  the  nature 
of  which  is  perhaps  sufficiently  indicated  by  their  names.  The  most 
important  are :  ordinary,  enterprise,  speculative,  monopoly,  and  acci- 
dental profits. 

Profits  and  Significance. — One  has  no  difficulty  showing 
that  profits  are  in  some  sense  or  degree  correlated  to  a  service  ren- 
dered, a  significance  in  economic  relations  belonging  to  the  part  per- 
formed by  the  receiver  of  the  profits.  Further,  profits  are  undoubt- 
edly in  some  sense  or  degree  proportioned  to  the  significance  or 
magnitude  of  the  service  rendered.  Thus,  all  must  admit  that  those 
persons  who  initiate  a  commercially  dubious,  but  socially  important, 
enterprise  perform  a  greater  service  than  those  who  carry  on  the 
same  in  later  years  when  success  is  assured ;  and,  undoubtedly,  the 
profits  must  commonly  be  larger  for  the  former  persons  than  for  the 
latter.  But,  admitting  a  rough  correspondence  between  profits  and 
the  service  rendered,  it  does  not  seem  possible  to  affirm  quite  the 
same  degree  of  correspondence  as  in  the  case  of  wages,  interest,  and 
rent. 


500  PRINCIPLES  OF  ECONOMICS  [XLI 

Where  profits  are  accidental,  the  correspondence  between  services 
rendered  and  reward  received  is  of  course  slight.  Such  profits  do 
not  tend  to  express  the  marginal  significance  of  the  receiver's  con- 
tribution. 

Monopoly  profits  doubtless  correspond  rather  closely  to  the 
marginal  significance  of  the  supply  of  service  actually  rendered,  but 
not  to  the  marginal  significance  of  the  supply  of  service  which  would 
naturally  be  rendered.  The  monopolist,  by  limiting  the  output  of  his 
product,  raises  its  marginal  utility,  and  so  its  price,  above  the  mar- 
ginal utility  which  the  product  would  naturally  have.  In  doing  this, 
he  obviously  raises  his  own  profits  above  the  amount  which  would 
express  the  marginal  utility  of  his  services,  were  no  limitations  set 
on  their  output. 

One  qualification  must,  however,  be  added.  The  monopoly  which 
temporarily  exists  may  have  been  anticipated,  and  may  have  been 
one  of  the  necessary  conditions  which  induced  capitalists  to  under- 
take the  industry  in  question.  Hence  we  may  say  that  the  monopo- 
listic output  is  after  all  the  natural  one  and  so  that  monopoly  profit 
comes  fully  under  the  service-value  principle.  Cases  of  this  sort  are 
supplied  by  the  legal  monopoly  of  patents,  copyrights  and  franchises, 
and  by  the  quasi-monopoly  of  new  enterprises.  Here  the  extra  profit 
does  not  correspond  merely  to  the  higher  valuation  by  supra-marginal 
buyers  of  the  service  rendered,  but  also  to  the  additional  service. 
For,  surely,  there  is  an  additional  service  when  men  undertake  to 
try  out  the  feasibility  of  a  new  enterprise, — giving  the  public  an 
opportunity  to  see  the  real  utility  of  the  service  or  commodity  which 
the  enterprise  supplies. 

Yet  in  spite  of  this  qualification  of  our  first  statement,  economists 
are  not  generally  disposed  to  affirm  the  service-value  principle  for 
monopoly.  The  presence  of  monopoly  at  any  point  more  or  less 
seriously  interferes  with  the  realization  of  the  principle.  Hence, 
assuming  for  the  moment  that  the  principle  is  a  good  one  in  an 
economic  order,  then  monopoly,  if  necessary  or  permitted,  ought  to 
be  regulated  or  controlled  in  the  public  interest. 

The  argument  for  enterprise  profits  has  been  more  or  less  antici- 
pated in  the  preceding  paragraphs.  Such  profits  somewhat  resemble 
prizes.  Many  persons  get  nothing ;  a  few  get  large  rewards.  Under 


XLI]  PROFITS  501 

these  conditions,  we  can  scarcely  expect  profits  to  express  with  great 
precision  the  contribution  of  the  profit-receiver.  Yet  we  should  not, 
on  the  other  hand,  imagine  that  the  two  are  entirely  divorced.  Op- 
portunities for  exploiting  novel  enterprises  are  constantly  arising; 
competition  for  such  opportunities  is  kept  fairly  brisk;  the  goods 
produced  must  command  prices  expressing  their  marginal  utility ; 
the  marginal  contributions  of  the  other  factors  are  at  the  same  time 
being  more  or  less  fully  determined  in  other  fields ;  and  it  seems  not 
unreasonable  to  assume  that  the  residuum  of  product — which  consti- 
tutes profits — is  properly  credited  to  the  entrepreneur  as  his  con- 
tribution. 

That  ordinary  profits,  if  they  exist  at  all,  tend  to  express  the 
marginal  significance  of  the  entrepreneur's  contribution,  seems  to 
need  no  further  discussion.  Here  the  elements  of  change  and  un- 
certainty are  reduced  to  a  minimum;  so. that  the  economic  processes 
which  tend  automatically  to  secure  each  factor  a  share  representing 
its  contribution  to  the  joint  product,  meet  little  hindrance. 

Profits  and  Disutility. — We  have  seen  that  the  significance 
half  of  our  principle  does  not  very  clearly  dominate  profits.  How 
about  the  disutility  part?  It  seems  plain  that  disutility  would  have 
little  influence  on  accidental  or  monopoly  profits.  Ordinary  profits, 
however,  it  would  seem,  must  express  with  fair  precision  the  mar- 
ginal disutility  of  supplying  the  entrepreneur  service.  First,  the 
demand  of  the  public  must  insure  for  a  product  a  price  high  enough 
to  cover  the  disutility  undergone  by  the  entrepreneur ;  since  other- 
wise production  will  cease,  supply  will  fall  off,  and  so  price  will  rise. 
Second,  the  competition  of  entrepreneurs  will  keep  price  from  going 
higher  than  the  above  point ;  since  their  numbers  can  be  recruited 
at  all  times  from  those  capitalists  who  merely  furnish  waiting 
power,  who  lend  their  capital  rather  than  invest  it. 

In  the  case  of  enterprise  profits,  also,  correspondence  between  the 
disutility  and  its  reward  seems  necessary  from  the  same  reasoning, 
though  here  the  correspondence  is  less  precise.  The  objection  is 
sometimes  raised  that  there  is  too  much  chance  in  these  cases  to 
insure  any  particular  result.  Thus  the  price  of  a  product  may  fail  to 
cover,  not  only  the  peculiar  disutility  of  the  entrepreneur,  but  even 


502  PRINCIPLES  OF  ECONOMICS  [XL1 

the  ordinary  outlay  for  material,  wages,  and  capital ;  while  on  the 
other  hand,  it  may  cover  all  that  outlay  and  give  a  surplus  large 
enough  to  insure  almost  any  conceivable  risk  several  times  over. 
This  reasoning  quite  fails  to  recognize  the  real  nature  of  the  re- 
sponsibility-taking disutility.  It  consists,  not  of  a  chance  of  loss  to 
be  covered  by  insurance,  but  of  a  chance  of  loss  not  to  be  covered 
at  all.  To  induce  men  to  incur  that  disutility,  a  prize  or  bonus,  of 
larger  or  smaller  magnitude,  must  be  attainable  in  the  event  of 
success.  The  size  of  that  bonus  is  roughly  proportioned  to  the  risk, 
though  the  unit  of  variation  is  very  different  for  different  races; 
and,  having  been  fixed,  it  must  be  covered  in  the  price  of  the  product. 

ILLUSTRATIVE  PROBLEMS 

1.  "Profits  are  the  wages  of  management."     Criticize.    What  is  the 
test  of  whether  any  particular  function  is  an  entrepreneur's  function — 
whether  it  is  something  for  which  profits  are  paid?     What  in  the  nature 
of  the  corporation  as  a  form  of  business  association  makes  "management" 
particularly  inapt  as  a  description  of  the  peculiar  function  of  the  entre- 
preneur? 

2.  "Profits  constitute  nothing  more  than  an  insurance  fund  to  cover 
the  possible  losses  of  the  entrepreneur."     Criticize. 


CHAPTER  XLII 

CRITIQUE  OF  EXISTING  SYSTEM :  INTRODUCTORY 


A  Critique  of  the  Existing   Order  a  Legitimate  Task  of 
Economic  Science 

In  the  opinion  of  not  a  few  persons,  we  have  now  reached  the 
end  of  our  proper  task ;  we  have  covered  the  whole  field  which  can 
be  legitimately  included  in  a  purely  scientific  study  of  Economics, — 
the  analysis  of  the  existing  economic  order  in  respect  to  structure  and 
functions.  To  go  further  and  undertake  to  pass  judgment  on  the 
satisfactoriness  of  the  existing  order,  seems  to  these  persons  a  plain 
transcending  of  our  proper  sphere.  The  title  of  the  present  chapter 
shows  that  the  writer  does  not  share  that  opinion.  I  consider  it  a 
very  important  part  of  the  economist's  task  to  study  the  present 
order  in  respect  to  its  fitness  or  unfitness  to  realize  the  ends  for 
which  it  must  be  presumed  to  exist. 

Argument. — My  principal  reasons  for  holding  this  opinion 
are  as  follows  :  First,  in  dealing  with  the  existing  economic  order,  a^ 
with  any  structure  to  which  the  term  "organism"  can  be  applied,  thj 
most  strictly  scientific  study — one  which  has  no  other  end  than  a 
really  adequate  knowledge  of  the  facts — cannot  properly  omit  a 
consideration  of  the  fitness  of  the  several  organs  to  perform  wel. 
their  respective  functions.  What  physiologist,  after  determining  the 
function  of  some  bodily  organ,  would  consider  his  task  completed 
until  he  had  made  an  attempt  to  learn  the  degree  of  efficiency  at- 
tained by  the  organ  in  performing  its  function? 

But  the  study  of  the  working  fitness  or  unfitness  of  the  present 
economic  organism  has  another  and  more  practical  justification. 
That  organism,  in  both  structure  and  function,  is  to  a  considerable 

503 


504  PRINCIPLES  OF  ECONOMICS  [XLII 

extent  the  product  of  consciously  free  arrangement.  At  many 
points,  it  is  what  it  is  because  we  make  it  so.  Doubtless,  this  aspect 
of  the  matter  can  easily  be  exaggerated;  the  power  of  individuals 
or  of  society  as  a  whole  to  alter  the  system  in  fundamentals  can  be, 
and  commonly  is,  overstated.  But,  so  long  as  this  power  exists  in 
even  a  small  degree,  the  student  of  economics  is  surely  called  upon 
to  consider  the  fitness  of  the  system,  as  at  present  constituted,  to 
attain  its  proper  ends.  For  where  he  finds  it  fit,  he  will  wish  to  exert 
his  power  in  support  of  it,  and  where  he  finds  it  unfit,  he  will  wish 
to  have  it  changed. 

Rival  Candidates  for  the  Task. — It  may  be  objected  that, 
while  we  have  here  a  problem  which  imperatively  calls  for  solution, 
the  task  is  after  all  one  which  does  not  properly  fall  to  the  economist. 
The  solution,  of  course,  requires  economic  data;  but  the  problem 
itself  is  essentially  an  ethical  or  political  one.  Logical  consistency, 
therefore,  requires  that  the  economist,  while  furnishing  the  needed 
data  from  his  own  science,  should  leave  the  problem  as  a  whole  to 
the  men  who  can  claim  to  be  authorities  in  ethics  or  politics.  There 
is  no  doubt  some  force  in  this  contention;  but  it  does  not  seem  de- 
cisive. First,  we  must  always  remember  that  there  is  a  degree  of 
deference  to  logical  consistency  which  spells  pedantry  rather  than 
any  practical  good.  Secondly,  there  are  many  problems  in  which 
elements  from  different  fields  of  study  are  closely  commingled  ;  and  a 
person  who  undertakes  to  solve  these  problems  must  weigh  and 
pass  upon  the  elements  from  every  field.  This  means  that  such 
person  must  transcend  in  some  measure  the  strict  boundaries  of  his 
subject.  But,  if  none  of  the  persons  interested  can  make  an  abso- 
lutely legitimate  claim  to  the  task,  it  would  seem  reasonable  to  turn 
it  over  to  that  particular  one  whose  science  furnishes  the  larger 
number  and  the  more  difficult  of  the  data  necessary  to  a  solution.  In 
the  case  before  us,  this  condition  is  most  certainly  realized  by 
economics. 

Superior  Claims  of  Economics. — Economics,  then,  would 
seem  to  be  the  science  which  would  naturally  essay  the  task  of  ascer- 
taining how  far  the  present  economic  order  is  fitted  to  attain  the 


XLII]  CRITIQUE  OF  EXISTING  SYSTEM  505 

ends  for  which  it  must  be  presumed  to  exist.  We  do  not  mean  to 
suggest  that  moralists,  sociologists,  ct  al.,  should  be  stopped  from 
discussing  this  subject,  but  merely  that  economists  can  also  discuss 
it,  and  perhaps  with  more  propriety  than  any  other  group  of  thinkers. 
In  further  support  of  this  contention  we  may  remark  that  such  prac- 
tice is,  on  the  whole,  in  accord  with  the  best  traditions  of  our  science. 
Economists  of  standing,  whatever  their  initial  professions,  have 
rarely  failed  to  comment  upon  the  workings  of  our  system  from  the 
teleological  standpoint  and  even  to  argue  for  or  against  proposed 
changes. 

And  it  is  probable  that  the  instructed  public  give  more  weight 
to  the  verdicts  of  economists  regarding  such  matters  than  to  those 
of  any  other  class. 

II 
The  Question  at  Issue 

In  the  preliminary  account  with  which  this  course  began,  the 
existing  order  was  represented  as  a  coherent,  rational  whole,  a 
system  having  different  parts  devoted  to  different  functions,  all  co- 
ordinated into  a  great  harmonious  totality.  At  the  same  time,  we 
saw  that  the  organizing  and  regulating  of  this  great  totality  was  not 
conscious,  but  spontaneous,  automatic;  and  that  the  particular  eco- 
nomic process  having  most  part  in  creating  the  great  whole  and 
regulating  its  operations,  is  exchange,  and  especially  that  element  in 
exchange  which  we  know  as  value,  price.  We  explained,  further, 
that  it  is  price  chiefly  which  determines  what  things  shall  be  pro- 
duced, how  things,  when  produced,  shall  be  utilized,  and  what  pro- 
portion of  the  total  product  shall  fall  to  the  different  participants  in 
socialized  production.  In  the  present  and  succeeding  chapters  we 
try  to  answer,  not  exhaustively,  but  with  greater  fulness  than  here- 
tofore, the  question : 

How  far  is  this  automatically  regulated  economic  system  a  suc- 
cess in  attaining  the  ends  for  zvhich  it  exists?  Does  it  accomplish 
in  a  fairly  adequate  manner  its  special  task:  namely,  providing  for 
the  satisfaction  of  human  wants  in  so  far  as  this  is  dependent  on 
economic  goods? 


506  PRINCIPLES  OF  ECONOMICS  [XLII 

III 
Verdict  of  This  Text 

Favorable. — In  view  of  the  tone  of  many  previous  allusions 
to  this  question,  it  is  hardly  necessary  to  say  that  the  answer  here 
offered  is  on  the  whole  an  affirmative  one.  Broadly  speaking,  we 
look  on  the  existing  economic  order  as  measurably  realizing  the 
ideals  which,  considering  the  limitations  of  human  nature,  it  is 
reasonable  to  demand  from  such  a  system. 

Disclaimer. — But  in  taking  this  position  we  wish  to  disclaim 
in  the  most  emphatic  language  any  intention  of  representing  the 
present  order  as  a  perfect  one,  either  theoretically  or  practically. 
Its  ideals  are  below  the  highest,  though  necessarily  so  as  we  think ; 
and  its  practice  is  at  many  points  far  below  its  ideals.  Many  of  its 
failures  grow  out  of  the  limitations  of  human  nature ;  but  not  a  few 
are  needless — can  be  avoided.  Increased  interference  with  the 
actual  working  of  things,  both  through  private  and  governmental 
initiative — if  for  no  other  purpose  than  to  eliminate  elements  which 
are,  and  always  have  been,  inconsistent  with  the  system — is  impera- 
tively demanded.  Further,  there  can  be  no  doubt  that  a  degree  of 
governmental  interference  going  much  beyond  this,  and  limiting 
sharply  the  free  working  of  those  conditions  which  are  most  char- 
acteristic of  the  present  order,  ought  to  be,  and  will  be,  forthcoming 
in  the  near  future.  Whether  in  the  interest  of  society  as  a  whole  or 
of  those  individuals  on  whom  the  existing  system  presses  too  hardly, 
we  shall  doubtless  see  a  more  extensive  resort  to  governmental 
initiative,  a  greater  limitation  of  the  rights  of  property,  a  further 
restricting  of  the  rights  of  inheritance  and  bequest,  a  distribution  of 
tax  burdens  far  more  favorable  to  the  poor,  public  provision  for  old 
age  pensions,  and  so  on. 

System  in  Main  Outlines  Satisfactory. — In  a  word,  when 
we  defend  the  existing  order  we  merely  mean  to  affirm  that  that 
order  is  in  its  main  outlines  substantially  sound,  fitted  to  attain  the 
reasonable  ends  for  which  such  an  order  exists.  Looked  at  broadly, 


XLII]  CRITIQUE  OF  EXISTING  SYSTEM  507 

it  shows  itself  to  be  highly  efficient  and  as  much  in  accord  with  our 
moral  ideals  as  we  could  expect  in  view  of  human  weakness,  folly, 
and  wickedness.  The  general  plan  of  exchange-cooperation,  in- 
volving private  rather  than  public  initiative,  characterized  by  private 
property  in  capital  and,  for  most  purposes,  in  land,  with  production, 
consumption,  and  distribution  regulated  in  general  through  a  price 
resulting  from  free  economic  action,  is  more  likely  than  any  funda- 
mentally different  scheme  to  work  in  a  measurably  satisfactory 
fashion.  Increased  regulation  and  a  more  liberal  admixture  of 
socialistic  elements  may  improve  things ;  but  the  general  system,  the 
main  framework,  is  sound  and,  as  human  affairs  go,  fairly  adequate. 

IV 
Distribution  Logical  Starting  Point  of  Critique 

What  Wants  Constitute  the  Economic  End? — In  attempting 
to  answer  the  general  question  concerning  the  satisfactoriness  of 
the  existing  order,  we  begin  a  critique  of  that  order  in  respect 
to  distribution.  The  reason  for  this  should  readily  be  understood. 
Men's  wants  lie  at  the  root  of  any  economic  order;  and,  presum- 
ably, the  satisfaction  of  men's  wants  is  the  object  of  such  an  order. 
The  ultimate  test  of  an  order,  therefore,  must  be  its  success  in 
satisfying  these  wants.  But  the  phrase  "men's  wants"  is  ambiguous. 
Not  all  wants,  surely,  can  be  satisfied.  As  between  lesser  and 
greater  wants,  in  the  case  of  the  individual,  the  satisfaction  of  the 
latter  must  take  precedence.  As  between  different  individuals,  we 
might  set  up  any  one  of  many  standards.  Thus,  we  might  rate  the 
importance  of  wants  according  to  their  absolute  magnitude,  sup- 
posing it  possible  to  ascertain  this.  That  is,  we  might  treat  any 
want,  whether  that  of  a  person  contributing  much  to  the  general 
advantage  or  contributing  little,  as  having  an  importance  exactly 
proportioned  to  its  intensity.  Again,  we  might  recognize  the  total 
wants  of  every  person  as  having  equal  importance  with  the  total 
wants  of  every  other  person.  Still  again,  we  might  treat  the  wants 
of  different  persons  as  having  very  different  degrees  of  importance, 
according  as  the  part  played  by  these  persons  in  economic  matters 
is  of  little  or  of  great  importance.  And  many  other  standards  mighf 


508  PRINCIPLES  OF  ECONOMICS  [XLH 

be  imagined,  determining  just  what  are  the  wants  which  we  have 
in  mind  when  we  declare  that  the  end  of  economic  action  is  the  satis- 
faction of  "men's  wants." 

Function  of  Distribution  to  Answer. — But,  not  only  is  the 
phrase  "men's  wants"  an  ambiguous  one,  needing  definition  before 
we  can  proceed  to  pass  judgment  on  the  fitness  of  an  economic 
order  to  accomplish  its  task — providing  for  the  satisfaction  of  those 
wants, — the  process  by  which  this  defining  is  done,  the  process  by 
which  society  determines  what  are  the  "men's  wants"  that  should  be 
satisfied,  belongs  to  that  part  of  economics  which  we  have  called 
distribution.  We  could,  indeed,  conceive  an  economic  order  in 
which  the  state  directly  determined  the  importance  of  different 
wants  and  directly  provided  for  their  satisfaction  in  accord  with  that 
determination.  Such  a  system  has  been  tried  more  or  less  ade- 
quately at  different  times,  and  is  usually  designated  communism. 
It  is  more  or  less  fully  illustrated  in  the  life  of  the  family.  But  the 
present  economic  order,  as  also  the  much-advocated  system  of 
socialism,  solves  the  problem  by  authorizing  a  system  giving  to 
each  individual  a  certain  money  income  which  he  uses  to  buy  the 
commodities  or  services  which  constitute  his  real  income.  In  doing 
this,  the  state  determines  the  relative  importance  of  the  total  wants 
of  each  individual  over  against  other  individuals  and  leaves  the 
determination  of  the  importance  of  the  different  wants  of  the  in- 
dividual to  be  settled  according  to  his  own  ratings. 

Hence  Distribution  Our  Starting  Point. — But,  if  the  good- 
ness of  an  economic  order  must  be  judged  by  its  fitness  to  secure  the 
fullest  possible  satisfaction,  in  their  proper  proportion,  of  that  body 
of  wants  which  society  has  decided  are  the  ones  that  ought  to  be 
satisfied,  and,  if  such  deciding  by  society  is  effected  by  maintaining 
a  particular  system  of  distribution,  it  follows  that  said  system  is  the 
necessary  starting  point  of  any  critique  of  the  economic  order  in 
question.  Once  we  have  determined  whether  the  system  of  distri- 
bution is  or  is  not  reasonable,  the  rest  of  our  task  is  comparatively 
easy.  The  remaining  parts  of  the  economic  order  are  good  or  bad 
according  as  they  do  or  do  not  contribute  to  the  realization  of  the 


XLII]  CRITIQUE  OF  EXISTING  SYSTEM  509 

ends  implicitly  approved  in  the  system  of  distribution, — according, 
in  short,  as  they  are  or  are  not  consistent  with,  complemental  to, 
the  system  of  distribution.'1 

Qualifications. — This  broad  statement  of  the  matter  doubt- 
less needs  various  qualifications.  Certain  public  or  group  wants  are 
not  provided  for  in  the  system  of  distribution,  at  least  as  we  have 
treated  it.  But  this  qualification  is  manifest ;  and  the  state  has  no 
difficulty  making  its  wants  supersede  all  others,  either  by  coming 
on  the  market  with  a  buying  power  vastly  exceeding  that  of  any 
individual,  or  by  the  exercise  of  its  absolute  sovereign  authority. 

Another  qualification  is  needed  because  the  government,  believ- 
ing that  it  is  desirable  to  modify  in  some  particular  the  working  of 
the  system  of  distribution  and  despairing  of  being  able  to  do  this 
by  direct  means,  may  make  use  of  its  power  to  guide  the  employ- 
ment of  social  resources  in  order  to  accomplish  its  object  by  indirec- 
tion. Thus,  as  was  noted  quite  early  in  our  study,  a  characteristic 
feature  of  the  present  order,  in  its  actual  working,  is  the  govern- 
mental practice  of  producing  certain  necessaries  and  supplying  them 
to  the  public  either  gratuitously  or  at  a>  price  below  what  would  be 
possible  under  private  initiative. 

In  spite,  however,  of  these  and  other  possible  qualifications,  the 
soundness  of  the  general  proposition  laid  down  above  is  incon- 
testable. The  system  of  distribution  prevailing  at  any  moment  must 
be  interpreted  as  embodying  the  decision  of  society  in  respect  to  the 
body  of  wants  to  be  satisfied  through  the  working  of  the  economic 
order,  and  therefore  embodying  the  decision  of  society  as  to  what 
are  the  true  social  wants  arranged  in  the  order  of  their  importance. 
If  following  the  guidance  derived  from  this  system  of  distribution 
results  in  what  seeme,  on  other  grounds,  to  be  a  wrong  use  of  our 
resources,  this  must  be  viewed  as  an  indictment,  not  of  the  process 
whereby  production  is  regulated,  but  rather  of  the  system  of  dis- 
tribution which  society  has  authorized.  If  amendment  is  needed, 


1  This  argument,  when  combined  with  that  of  the  present  and  follow- 
ing chapters  defending  the  present  system  of  distribution,  has  been  objected 
to  on  the  ground  that  it  involves  circular  reasoning.  This  objection  will 
be  commented  on  in  Chapter  XLVI. 


510  PRINCIPLES  OF  ECONOMICS  [XLII 

that  amendment  should,  with  few  exceptions,  be  directed  to  the 
alteration  of  the  source  of  the  trouble,  the  system  of  distribution 
itself.  Accordingly,  our  critique  of  the  present  economic  order  be- 
gins with  a  consideration  of  the  reasonableness  of  the  system  of 
distribution  embodied  in  that  order. 


CHAPTER  XLIII 

CRITIQUE  OF  PRESENT  PRINCIPLE  OF  DISTRIBU- 
TION 

The  general  principle  underlying  the  present  system  of  distribu- 
tion, it  will  be  recalled,  runs  somewhat  as  follows : 

When  competition  is  free,  each  individual  tends  to  get  approxi- 
mately that  income  which  expresses  the  marginal  significance  of  the 
natural  supply  of  the  type  of  contribution  made  by  himself  or  his 
property  to  the  sum  of  utilities,  and  which,  at  the  same  time,  ex- 
presses approximately  the  net  marginal  disutility  involved  in  making 
that  contribution. 

Is  this  principle,  on  the  whole,  wise  and  just? 

No  adequate  answer  to  this  question  can  be  made  without  con- 
trasting the  principle  to  be  judged  with  possible  substitutes.  It  will 
perhaps  be  best,  therefore,  to  begin  our  critique  by  examining  some 
of  the  more  plausible  substitutes  that  have  been  suggested,  reviewing 
their  merits,  and,  if  such  exist,  their  logical  and  practical  defects. 


Proposed  Substitutes 

To  Each  According  to  His  Need. — One  principle  of  dis- 
tribution often  highly  commended  is  that  which  we  try  to  realize  in 
family  life,  as  also  in  the  life  of  the  state  during  periods  of  greatest 
social  exaltation.  I  mean  the  principle  that  each  shall  receive  of  the 
common  income  in  proportion  to  his  need, — having  given  in  propor- 
tion to  his  capacity.  This  seems  to  have  been,  and  to  be  still  the 
formula  of  the  highest  type  of  communism.  "From  each  according 
to  his  capacity;  to  each  according  to  his  need." 

To  the  present  writer  there  seems  no  room  for  argument  as  to 
the  ethical  superiority  of  this  distributive  ideal  over  all  others.  If 

5" 


512  PRINCIPLES  OF  ECONOMICS  [XLIII 

human  nature  were  capable  of  maintaining  it,  no  other  formula 
would  deserve  a  moment's  consideration.  But  unfortunately  there 
is  reason,  and  perhaps  quite  conclusive  reason,  to  doubt  the  suffi- 
ciency of  human  nature  in  this  regard.  Even  those  few  hundreds  of 
people  who  succeed  in  living  somewhat  near  such  an  ideal  in  Amana 
and  other  communistic  associations  admit  that  their  very  limited 
success  is  made  possible  only  because  of  certain  intense  religious 
sentiments  which  are  common  to  all  the  members.  And  no  one 
seriously  believes  that  uniform  sentiments  of  this  kind  exist,  or  can 
ever  possibly  exist,  in  more  than  a  small  minority  of  the  hundred 
millions  of  men,  women,  and  children  who  constitute  the  population 
of  the  United  States. 

Labor  Ideal. — Another  ideal  which  seems  to  have  been  more 
or  less  consciously  held  by  many  socialists  of  the  earlier  type,  is  that 
each  person  should  share  in  the  joint  income  in  proportion  to  his 
labor.  This  of  course  can  be  differently  interpreted.  One  may 
have  in  mind  the  sacrifice  made  or  the  results  accomplished.  And 
he  may  conceive  the  sacrifice  as  measured  in  a  subjective  standard  or 
as  measured  in  an  objective 'one,  like  time. 

In  general,  the  socialists  seem  to  have  had  in  mind  primarily  the 
sacrifice  of  labor  as  measured  by  the  time  spent  in  applying  it.  Yet 
they  tried  to  avoid  divorcing  this  completely  from  results,  by  in- 
sisting that  the  labor  must  be  labor  which  produced  things,  and 
standardized  labor  at  that, — labor  which  in  the  given  place  and  time 
was  "socially  necessary"  to  accomplish  the  result.  Marx  1  further 
conceded  that  we  could  not  treat  all  kinds  of  labor  as  exactly  the 
same,  though  he  would  not  admit  qualitative  differences.  The  labor 
of  the  artist  and  that  of  the  mechanic  must  be  treated  as  differing  in 
intensity,  or  density,  so  to  speak.  That  is,  one  hour  of  the  artist's 
labor  should  be  reckoned  as  the  equivalent  of,  say,  three  of  the 
mechanic's. 

The  labor  ideal  as  thus  interpreted,  though  not  without  points  of 
merit,  has  fundamental  defects  which  render  it  unworthy  of  ex- 
tended discussion.  Any  scheme  of  distribution  which  can  reason- 


1  The  most  eminent  of  the  theorists  who  laid  the  foundations  of  socialism. 


XLIII]  CRITIQUE  OF  DISTRIBUTIVE  PRINCIPLE  513 

ably  ask  for  society's  favor  must  in  serious  measure  make  economic 
reward  conditioned  upon  economic  significance,  must  make  differ- 
ences of  economic  reward  correlative  to  differences  in  economic 
significance.  This  Marx  tacitly  admits  by  refusing  to  reward  labor 
which  produces  nothing  useful,  and  by  insisting  that  all  labor  must 
be  standardized,  reduced  to  "socially  necessary  labor."  But  differ- 
ences in  the  economic  significance  of  the  several  kinds  of  labor  often 
show  no  correspondence  either  to  labor  time  or  to  labor  intensity. 
It  is  therefore  quite  out  of  the  question  that  labor  as  measured  in 
labor  time,  even  when  corrected  for  intensity,  should  be  accepted  as 
the  principle  of  distribution, 

Social  Service  Ideal. — Another  conceivable  ideal  of  distribu- 
tion, more  or  less  definitely  held  by  many  intelligent  people,  may  be 
called  the  social  service  ideal.  This  idea  differs  from  the  one  em- 
bodied in  the  present  order  in  that,  under  the  latter,  each  person 
receives  a  price  which  expresses  the  significance  of  his  services  to 
individuals  graded  according  to  the  buying  power  they  possess; 
while,  under  the  social-service  principle,  a  man  would  be  paid  ac- 
cording to  the  significance  of  his  services  to  the  group  as  a  whole  or 
to  all  individuals  without  any  reference  to  their  wealth  or  poverty. 

This  ideal  has  at  the  first  hearing  an  extremely  plausible  sound. 
There"  is  something  particularly  obnoxious  in  the  fact  that,  under  the 
present  system,  the  power  to  furnish  services  of  a  very  trivial  sort, 
or  even  services  highly  immoral  in  their  character,  enables  the 
owner  to  command  a  large  income,  because  persons  desiring  such 
services  chance  to  possess  great  buying  power.  It  would  seem  much 
more  equitable  that  one's  income  should  depend  upon  the  services 
of  real  worth  which  he  renders  direct  to  the  humanity  which  is  in 
all  men  alike,  or  to  the  worthiest  needs  and  demands  of  the  entire 
social  group. 

But  further  examination  shows  this  principle  to  be  seriously 
deficient.  First,  in  so  far  as  it  concerns  the  group  as  a  whole,  the 
new  principle  is  already  contained  in  the  one  which  governs  our 
present  system.  The  group  is  fully  organized  and,  through  the  use 
of  the  sovereign  power  of  taxation,  can  insure  that  group  wants  are 
satisfied  at  whatever  cost, — can  see  in  other  words,  that  men  are  paid 


514  PRINCIPLES  OF  ECONOMICS  [XLIII 

in  accord  with  the  importance  of  the  service  they  render  to  the 
group. 

Secondly,  the  proposed  ideal,  as  applied  to  individuals,  is  self- 
contradictory.  For  a  principle  of  distribution  simply  cannot  pay 
according  to  the  importance  of  the  service  rendered  without  paying 
according  to  the  importance  of  the  service  to  individuals  graded 
according  to  buying  power.  ( i )  Since  men  are  to  be  paid  in  accord 
with  services  rendered,  they  are  to  be  paid  unequally.  (2)  This 
means  that  the  effective  demand  for  commodities  and  services  will 
be  unequally  distributed.  (3)  But  the  distribution  of  effective  de- 
mand will  necessarily  determine  in  what  proportions  people  will 
actually  consume  goods.  (4)  But  the  only  importance  which  can 
signify  anything  is  importance  to  actual  consumers.  (5)  It  follows, 
therefore,  that  to  pay  for  services  according  to  their  importance  to 
individuals  without  discrimination  as  to  wealth  or  poverty,  is  to  pay 
for  those  services  in  accord  with  their  importance  to  persons  who 
do  not  get  them  at  all, — a  process  which  really  amounts  to  paying 
for  services  without  regard  to  their  importance. 

Equality  Ideal. — The  last  ideal  of  distribution  which  we 
shall  here  discuss  is  that  of  equality.  To  each  an  equal  share,  but 
from  all,  service,  is  its  motto.  This  is  the  more  usual  communistic 
ideal,  and  it  is  apparently  favored  by  many  socialists.  Nor  can 
we  wonder  at  its  popularity,  for^there  is  indeed  much  to  be  said  in  its 
support.  The  greatest  discomfort  from  poverty — not  the  absolute 
want  of  the  poor,  but  their  contrast  with  more  favored  neighbors, — 
would,  under  such  a  principle,  be  overcome.  Further,  equality 
would  not  fail  to  bring  a  degree  of  satisfaction  to  many  people, 
those  who  descended  as  well  as  those  who  rose,  even  if  the  equality 
were  one  but  little  removed  from  misery. 

But,  after  all,  this  principle  is  quite  impracticable.  Equality  in 
income,  though  serving  well  various  sentimental  considerations, 
would  sacrifice  to  these  the  real,  material  welfare  of  all  classes. 
Further,  it  would  not  even  embody  the  ethical  ideals  which  dominate 
practically  the  whole  community.  For,  however  people  may  feel 
toward  interest,  rent,  and  profits,  they  almost  universally  believe 
that  wages  and  salaries  ought  to  bear  some  relation  to  service. 


XLIII]  CRITIQUE  OF  DISTRIBUTIVE  PRINCIPLE  5^ 

Need  for  Inequality. — But  the  subject  is  too  important  to  be 
so  lightly  disposed  of.  Are  we  right  in  saying  that  an  attempt  to 
enforce  complete  equality  would  sacrifice  the  real  material  welfare 
of  all  classes  to  mere  sentimental  considerations?  In  support  of 
this  view,  there  are  three  chief  sets  of  facts. 

Efficiency  in  Important  Functions. — In  the  first  place,  giving 
some  persons  larger  incomes  than  the  rest  of  us  may  be  directly 
required  in  the  interests  of  the  rest  of  us,  in  that  the  larger  incomes 
are  necessary  to  enable  those  persons  to  perform  efficiently  the  im- 
portant tasks  we  have  assigned  them.  Thus  no  thoughtful  person 
would  contend  that  the  people  of  the  United  States  could  afford  to 
have  their  chief  executive  live  on  $1,000  a  year,  even  if  he  were 
perfectly  willing  to  do  so.  To  perform  at  all  well  his  services  to  the 
people  of  the  nation,  he  must  spend,  on  matters  more  or  less  per- 
sonal in  their  nature,  many  times  $1,000.  What  is  true  of  the  presi- 
dent of  a  great  republic  is  true  in  only  lesser  degree  of  hundreds  of 
other  men.  In  fact,  if  we  sufficiently  narrow  the  circle  of  interested 
persons,  it  is  true  in  a  way  for  almost  every  male  citizen.  To  the 
other  members  of  his  family,  it  is  more  important  that  the  bread- 
winner, though  the  humblest  of  day-laborers,  should  be  well  fed 
than  that  the  rest  should  be,  because  only  so  can  he  be  fit  to  earn 
the  income  on  which  they  all  depend.  But,  of  course,  the  point  is 
more  forcefully  illustrated  in  the  greater  relations  of  society.  To 
those  men  whose  functions  involve  large  responsibilities,  intense 
mental  activity,  and  great* nerve  strain,  we  must,  for  our  own  sakes, 
give  large  incomes,  in  'order  that  they  may  prove  resolute,  clear- 
sighted, well-poised,  and  in  other  respects  fitted  for  their  great  tasks. 

The  objector  may  say  that  we  really  have  here  a  case  not  of 
better  income,  but  rather  of  collateral  expenses.  Needs  of  this  kind 
should  be  provided  for  as  part  of  the  outlay  of  the  office  which  the 
man  holds.  If  $1,000  is  the  best  income  the  community  can  afford 
its  members,  the  president,  as  a  man  must  be  satisfied  with  that  in- 
come; though  on  his  office  we  may  spend  $100,000.  Doubtless  some- 
thing, perhaps  much,  could  be  done  along  this  line ;  the  writer  heart- 
ily believes  in  employing  such  a  policy  wherever  possible.  But  the 
whole  difficulty  could  not  be  met  in  this  way.  A  need  is  often  so 


5i6  PRINCIPLES  OF  ECONOMICS  [XLIII 

personal,  so  individual,  in  character  that  it  cannot  be  provided  for 
save  through  a  fund  placed  at  the  disposal  of  the  person  interested. 
One  person  requires  one  sort  of  relaxation,  perhaps  a  very  inex- 
pensive one;  another  requires  a  very  different  sort,  perhaps  a  very 
costly  one.  Further,  the  employing  public  (under  socialism),  whose 
opinion  is  greatly  influenced  by  persons  not  in  a  position  to  judge 
of  the  personal  needs  attaching  to  the  higher  social  functions,  would 
commonly  underrate  those  needs,  as  is  shown  in  the  niggardly  sal- 
aries now  paid  public  officials  in  democracies.  In  consequence,  pro- 
vision for  this  kind  of  need,  if  made  in  a  formal  sort  of  way,  would 
probably  be  far  too  small. 

Proper  Assignment  of  Factors:  Disutility. — The  preceding 
paragraph  has  named  one  reason  why  inequality  of  incomes  is  neces- 
sary in  the  interest  of  the  very  persons  whose  apparent  incomes 
would  be  raised  by  the  abolition  of  that  inequality.  A  second  is 
found  in  the  fact  that  unless  incomes  are  unequal,  they  will  not 
even  approximately  express  the  relative  sacrifices  which  men  un- 
dergo in  contributing  different  services,  and,  so  will  induce  an  over- 
supply  of  services  which  involve  small  sacrifices  and  an  undersupply 
of  the  opposite  kind. 

This  difficulty  has  always  been  recognized  by  the  creators  of 
Utopias;  and  to  meet  it  a  great  variety  of  ingenious  schemes  have 
been  devised.  Thus,  some  writers  have  proposed  that  conscripts 
from  all  classes  should  have  to  serve  a  certain  length  of  time  in 
objectionable  trades.  Others  have  reserved  these  occupations  for 
the  convicts.  More,  recently,  we  have  had -much  stress  laid  on  (i) 
variations  in  the  length  of  the  labor  day  and  (2)  honor  rewards.  An 
undesirable  occupation  might  be  made  less  unattractive  by  reducing 
the  day  from  6  hours  to  4,  or  3.  So,  attractiveness  might  be  given 
the  occupation  by  attaching  thereto  decorations  and  official  rank. 

Now,  it  seems  highly  improbable  that  these  devices  should  have 
anything  like  the  effectiveness  which  is  anticipated  from  them.  The 
honor  device,  especially,  overlooks  the  fact  that  hc&iors,  to  be  effec- 
tive as  a  stimulus  to  emulation,  must  not  be  too  commonly  employed. 
Gaining  a  prize  is  not  worth  while,  if  almost  all  the  contestants  gain 
prizes.  Being  a  member  of  an  academy  which  everyone  can  join 


XLIIIJ  CRITIQUE  OF  DISTRIBUTIVE  PRINCIPLE  5I7 

by  paying  $5,  will  attract  people  only  so  long  as  they  are  ignorant 
of  the  facts.  But,  whether  these  schemes  are  practicable  or  not, 
there  can  be  no  doubt  that  they  are  inconsistent  with  real  equality. 
Why  do  I  object  to  my  neighbor's  having  a  better  income  than  I, 
supposing  mine  to  be  enough  for  a  decent  life?  Mainly,  it  is  because 
the  spectacle  of  his  enjoying  advantages  which  I  cannot  enjoy  de- 
tracts from  my  peace  of  mind.  Now,  what  matter  as  to  the  source 
of  these  advantages?  To  see  him  watching  the  great  national  game, 
or  comfortably  lying  in  the  shade,  while  I  toil  and  sweat  in  the  sun, 
would  surely  awake  in  me  an  unpleasant  sense  of  contrast  if  these 
privileges  were  granted  him  as  a  direct  reward  for  accepting  some 
task,  just  as  truly  as  they  now  do,  when  they  come  as  an  indirect 
reward  for  that  same  service.  So,  again,  one  of  the  greatest  objec- 
tions to  the  inequality  of  the  present  order  is  that  it  gives  to  the 
men  of  larger  incomes  a  higher  place  in  the  estimation  of  their 
fellows,  better  social  standing.  Will  this  deeper  sort  of  inequality 
be  any  less  obnoxious  when  it  is  directly  created  than  when,  as  at 
present,  it  is  the  indirect  result  of  inequality  in  money  income? 

Proper  Assignment  of  Factors:  Significance.- — There  is  still 
a  third  reason — and  this  is  the  weightiest  of  all — why  people  gen- 
erally, considered  as  consumers,  must  in  their  own  interest  prefer 
that  some  other  persons  should  receive  better  incomes  than  them- 
selves. There  must  be  inequality  of  incomes,  some  contributions 
must  command  much  higher  prices  than  other  contributions,  because 
only  in  this  way  can  it  be  made  certain  that  society  will  make  the 
best  use  of  its  resources,  its  productive  capacities. 

In  an  earlier  discussion  it  was  shown  that,  in  a  world  like  ours 
where  different  kinds  of  primary  factors,  limited  in  amount  and 
capacity,  enter  in  different  proportions  into  the  production  of  differ- 
ent commodities,  each  of  those  kinds  of  factors  unit  have  its  own 
special  significance  or  importance  as  determined  by  its  contribution 
to  the  production  of  goods.  Further,  under  the  present  system  of 
free  private  initiative  and  exchange,  insuring  that  each  factor  has  a 
price  which  expresses  approximately  its  true  significance  is  accom- 
plished automatically.  Now,  by  some  process  or  other,  the  same 
task  must  be  performed  under  any  system  of  economic  organization 


518  PRINCIPLES  OF  ECONOMICS  [XLIII 

— communism,  socialism,  or  what  not.  For,,  otherwise,  we  could 
have  no  assurance  that  we  were  making  the  best  use  of  our 
capacities. 

Proper  Valuation  of  Services  Necessary. — First,  the  mere 
assigning  to  things  of  their  proper  prices  would  be  necessary  under 
socialism  no  less  than  under  the  present  order,  a&  a  part  of  the  public 
system  of  bookkeeping.  For,  if  the  state  were  to  become  the  sole 
landlord,  capitalist,  and  entrepreneur,  it  would  be  obliged  to  carry  on 
an  elaborate  and  complete  system  of  bookkeeping  in  order  to  have  at 
hand  the  knowledge  of  conditions  necessary  to  a  reasonable  conduct 
of  economic  affairs ;  and,  in  this  bookkeeping,  the  state  would  need 
to  credit  each  primary  factor  with  the  true  significance  of  that  fac- 
tor, since,  otherwise,  it  would  frequently  waste  important  factors  on 
unimportant  commodities.  In  short,  whether  or  not  men  were 
actually  to  receive  unequal  incomes,  they  -would  have  to  be  credited 
with  unequal  contributions. 

Corresponding  Income  Probably  Necessary. — But  when  each 
person  has  been  credited  with  the  true  value  of  his  contribution,  can 
it  be  doubted  that,  under  any  system  which  is  in  the  remotest  degree 
practicable,  that  value,  or  something  approximating  it,  would  have 
to  be  paid  to  the  man  who  made  the  contribution  ?  We  say  "under 
any  system  which  is  in  the  remotest  degree  practicable";  for  one 
might  admit  that  a  despotically  organized  communism,  effecting  and 
regulating  cooperation  through  authority,  could  "exploit  the  work- 
ers"— to  use  a  socialist  phrase — could  give  equal  remuneration  for 
very  unequal  services.  But  surely  no  communistic  plan  yet  proposed 
is  to  be  taken  seriously.  We  need,  therefore,  to  consider  only 
socialism.  Would  that  system  of  economic  organization  be  driven 
to  pay  men  in  proportion  to  their  contribution? 

True  Under  Socialism. — The  answer  is  surely  an  affirmative 
one.  We  could,  indeed,  conceive  a  socialist  state  which  at  first 
thought  would  seem  able  to  avoid  the  necessity  of  adjusting  reward 
to  contribution ;  I  mean  a  state  conterminous  with  the  earth  and 
organized  as  a  completely  centralized  despotism.  Such  a  state  might 


XLIII]  CRITIQUE  OF  DISTRIBUTIVE  PRINCIPLE 

seem  to  be  emancipated  from  all  necessity  for  paying  its  workers 
according  to  any  standard  other  than  its  own  will,  because  competi- 
tion would  have  been  completely  eliminated.  As  a  matter  of  fact, 
however,  I  doubt  if  even  this  vast  despotism  would  be  able  to  exploit 
the  capable  in  the  way  supposed,  and  that  for  two  reasons:  (i)  the 
capable  would  probably  be  in  power,  and  (2)  whether  or  not,  they 
would  know  their  own  importance  and,  by  a  refusal  to  work  for  less, 
would  compel  the  authorities  to  raise  their  pay  till  it  approximated 
the  real  value  of  their  services.  But  it  surely  is  wasting  time  to 
build  upon  the  fantastic  assumption  of  a  cooperative  commonwealth 
coextensive  with  the  earth  and  organized  as  a  completely  centralized 
despotism.  If  we  ever  have  a  collectivist  state,  it  will  be  one  among 
many  sovereign  states,  and  one  in  which  local  autonomy,  municipal 
and  provincial,  still  exists.  It  will,  therefore,  be  a  state  in  which 
competition  still  exists.  Different  municipalities,  different  common- 
wealths, different  sovereign  states  will  more  or  less  vie  with  each 
other  in  trying  to  attain  the  highest  efficiency,  and  so  will  drive  one 
another  into  paying  the  persons  who  supply  the  different  kinds  of 
productive  services  something  like  what  those  services  are  worth. 
But,  in  doing  this,  they  will  of  course  make  the  shares  of  these  per- 
sons in  the  social  income  unequal. 

In  short,  while  inequalfties  in  distribution  need  not  always  be  so 
great  as  they  are  today,  while  they  would  be  much  reduced  under  a 
socialist  regime  and  no  doubt  will  be  much  reduced  under  the  present 
regime — still,  inequality  of  some  degree  is  inevitable.  The  ideal 
which  would  give  to  each  citizen  an  equal  share  with  every  other  is 
quite  out  of  the  question.  The  remuneration  received  by  each  must 
bear  some  relation  to  his  contribution. 

Summary. — Finally,  as  a  general  result  of  the  discussion 
in  this  entire  chapter,  what  do  we  have?  We  have  examined  all  the 
chief  substitutes  for  the  existing  principle  of  distribution  that  have 
been  proposed ;  and  while  we  have  found  them  commendable  in 
many  respects,  and  especially  as  regards  their  humanitarian  purpose 
or  intent,  we  have  also  found  them  one  and  all,  on  the  whole,  im- 
practicable,— it  is  doubtful  whether,  for  the  present  at  least,  they 
can  be  established.  This  being  true,  it  is  virtually  certain  that  the 


520  PRINCIPLES  OF  ECONOMICS  [XLIII 

existing  principle,  with  possible  modifications,  will  for  some  time  be 
continued.  It  therefore  becomes  of  the  first  importance  to  determine 
whether  that  principle,  since  it  needs  must  be  endured,  is  any  more 
defensible  than  these  others.  To  that  task  we  shall  turn  in  the  fol- 
lowing chapter. 

II 
Defense  of  Service-Value  Principle 

We  have  tried  to  prepare  the  way  for  a  defense  of  the  existing 
system  of  distribution,  especially  in  respect  to  its  general  principle 
or  ideal,  by  showing  the  impracticability  of  the  ideals  which  have 
been  proposed  as  substitutes  for  the  one  dominating  the  present 
order.  We  now  undertake  a  brief  defense  of  the  general  principle 
of  the  existing  system,  leaving  to  the  succeeding  chapter  a  defense 
of  the  more  prominent  features  of  the  system  of  distribution  that 
appear  in  the  working  out  of  its  principle. 

Service-Value  Principle  Necessary. — That,  under  any  social 
order  which  retained  any  degree  of  individual  liberty  and  local 
self-government,  the  acceptance  of  the  service-value  principle  or 
ideal  would  be  practically  necessary  in  the  interest  of  mere  economic 
efficiency, — has  already  been  established*  in  showing  the  impossi- 
bility of  the  equality  of  the  ideal.  Even  under  socialism,  we  should 
be  driven  to  pay  men  for  their  services  in  substantial  accord  with 
the  effective  importance  or  value  of  those  services;  for  only  so 
could  we  assure  the  assignment  of  those  services  to  their  proper 
tasks.  We  shall  now  comment  briefly  on  special  objections  to  the 
dominance  of  this  principle. 

Generic  versus  Specific  Utility. — There  appears  among 
many  people  a  disposition  to  criticize  the  ruling  principle  of  distri- 
bution because  it  pays  men  in  accord  with  their  effective  or  specific 
utility  rather  than  their  generic  or  class  utility.  Thus,  the  utility  of 
coal  miners  as  a  class  is  surely  far  greater  than  that  of  high-grade 
singers  as  a  class ;  but  society  pays  a  miner  for  an  hour's  work,  per- 
haps, 40  cents,  while  it  pays  the  singer  for  an  hour's  work,  perhaps, 
$2,000.  This  objection  always  arouses  a  sympathetic  response  in  the 
popular  mind ;  but  to  the  student  who  has  acquired  a  fuller  compre^ 


XLIII]          CRITIQUE  OF  DISTRIBUTIVE  PRINCIPLE  521 

hension  of  economic  relations,  it  is  quite  without  point.  A  person 
who  puts  forward  this  objection  really  admits  by  implication  that  it 
is  right  to  have  men  paid  in  accord  with  the  importance  of  their 
services;  he  only  complains  that  we  set  the  wrong  standard  for  judg- 
ing importance.  But  his  complaint  is  of  course  a  mistaken  one.  The 
real  importance  of  any  man  is  his  effective  importance, — what  we 
should  lose  if  we  lost  him,  not  what  we  should  lose  if  we  lost  his 
whole  class.  •  For  usually  the  alternative  facing  us  is,  not  keeping 
or  losing  the  whole  class,  but  keeping  or  losing  an  individual  of  the 
class. 

And  what  we  lose  by  losing  any  individual  of  a  class  is  only 
the  utility  of  the  least  useful  of  the  class,  since  the  loss  of  any 
higher  utility  would  be  avoided  by  transferring  the  least  important 
member  of  the  class  from  his  present  task  to  the  higher  one. 

One's  Own  versus  Marginal  Utility. — Another  familiar  ob- 
jection to  the  service-value  principle  is  that  it  pays  a  man,  not  in 
accord  with  his  o*wn  specific  utility,  but  in  accord  with  the  utility  of 
the  marginal  member  of  his  class.  Thus,  a  man  may  be  performing 
some  service  for  which  his  employer  is  glad  to  pay  him,  and  does  pay 
him,  $2  a  day ;  when,  without  any  fault  on  his  part,  an  increased 
supply  of  labor  comes  on  the  market  and  lowers  the  marginal  utility 
of  his  class  to  $1.50  per  day,  with  the  final  result  that,  though  still 
performing  the  $2  service,  he  now  gets  only  $1.50.  Viewed  from 
this  man's  standpoint  the  situation  naturally  makes  a  powerful 
appeal  to  one's  sympathies.  But  what  about  the  incoming  man? 
He  surely  cannot  be  paid  more  than  the  $1.50  which  he  really  earns. 
But,  if  the  first  man  continues  to  get  $2,  while  this  second  one  who 
is  working  just  as  hard  and  is  perfectly  able  to  replace  the  former 
gets  only  $1.50,  our  sense  of  justice  would  be  outraged  just  as  much 
as  in  the  former  case. 

But,  again,  the  objection  is  quite  untenable  logically.  As  we  said 
above,  if  a  man  is  to  be  paid  in  accord  with  his  importance  at  all, 
the  importance  in  question  must  be  his  real,  effective  importance. 
But  the  real,  effective  importance  of  a  man  is  determined,  not  by  the 
importance  of  the  thing  he  accomplishes,  but  by  the  importance  of 
the  thing  which  the  marginal  member  of  his  class  accomplishes, 


522  PRINCIPLES  OF  ECONOMICS  [XLIII 

Justice  versus  Mere  Economic  Value. — Probably  the  mis- 
giving which  most  persistently  recurs  to  all  of  us  concerning  the 
service-value  principle,  is  that  to  defend  or  even  patiently  accept  it 
one  must  be  somehow  too  cold-blooded,  too  insensible  to  considera- 
tions of  sympathy,  humanity,  love  of  one's  fellows.  When  one  is 
exercising  his  logical  faculties  on  mere  abstractions  or  is  dealing 
with  mere  things,  he  can  recognize  the  working  of  an  inflexible 
scientific  principle  without  a  qualm.  But  here  the  interests  at  stake 
are  the  incomes  and,  therefore,  the  happiness  of  living  human  beings. 
Is  there  not  something  inherently  shocking  to  our  moral  sense,  even 
to  our  sense  of  mere  decency,  in  the  advocacy  or  adoption  of  a 
principle  which  places  interests  like  these  at  the  mercy  of  so  unmoral 
a  thing  as  the  law  of  supply  and  demand,  or  the  law  of  marginal 
utility?  Does  not  every  right-minded  man  respond  with  full  ap- 
proval to  the  belief  expressed  by  Mill  that  a  time  will  come  when  the 
division  of  society's  product,  instead  of  being  a  matter  of  automatic, 
mechanical,  regulation,  "would  be  made  by  concert  on  an  acknowl- 
edged principle  of  justice?"  In  fact,  is  not  this  whole  attitude  of 
mind  which  conceives  human  beings  as  mere  instruments,  mere 
things,  inherently  wrong?  Must  we  not  rather  at  all  times  con- 
ceive human  beings  as  ends  in  themselves? 

Now  there  is  surely  some  force  in  all  this.  We  saw  in  the  pre- 
ceding chapter  that  it  is  at  least  possible  to  imagine  a  principle  dif- 
ferent from,  and  higher  than,  the  one  now  operative.  We  believe 
also  that  the  working  of  the  principle  in  the  actual  order  can  be 
greatly  improved  by  changes  which  would  better  satisfy  the  de- 
mands of  moral  and  humanitarian  sentiment  above  alluded  to.  And 
we  believe  that  its  worst  tendencies  could  be,  and  are,  not  a  little 
offset  by  a  secondary  distribution  through  voluntary  benevolence 
and  the  use  of  the  taxing  power, — all  this  in  obedience  to  the  same 
moral  and  humanitarian  sentiment.  But,  when  all  is  said  and  done, 
we  can  only  imagine  a  radically  different  system — not  really  estab- 
lish it.  We  can  only  modify  the  working  of  the  present  principle, 
not  overthrow  it;  we  have  no  choice  but  to  submit  to  the  principle 
as  it  is.  Whether  the  principle  shocks  our  sentiments  or  not,  there- 
fore, the  least  we  can  do  as  scientific  students  is  frankly  to  recog- 
nize its  reality. 


XLIII]  CRITIQUE.  OF  DISTRIBUTIVE  PRINCIPLE  523 

But  in  fact  there  is  no  good  reason  why  the  existing  principle 
of  distribution  should  offend  our  moral  sentiments.  Rather,  the 
contrary.  If  the  service-value  principle  is  the  only  one  which  can 
sustain  society  from  falling  into  the  poverty  and  misery  of  com- 
munism, then  it  would  not  be  difficult  to  make  out  a  case  showing 
the  principle  to  be  positively  humanitarian.  Nor  need  we,  in  the 
second  place,  feel  too  keen  a  response  to  the  notion  that  it  is  wrong 
ever  to  conceive  of  human  beings  as  functioning  in  some  relations 
like  mere  instruments  or  things. 

There  is  nothing  per  se  unworthy  or  degrading  in  taking  one's 
turn  at  being  a  mere  thing  in  economic  society.  Doubtless  we  all 
ought  to  have  our  opportunity  to  live  for  living's  sake,  to  be  ends 
rather  than  means.  But  this  is  perfectly  consistent  with  our  being, 
much  of  the  time,  mere  means  to  an  end.  Further,  it  is  quite  easy 
to  overstate  the  case.  Men  are  prone  to  overemphasize  their  right 
to  be  "ends  in  themselves."  Most  men  of  mature  years  have  learned 
that,  in  the  long  run,  scarcely  anything  is  really  worth  while,  even 
from  the  purely  selfish  standpoint,  except  to  set  oneself  a  suitable 
task  and  endeavor  conscientiously  to  perform  it.1 

1  By  a  curious  inconsistency,  people  who  emphasize  this  objection  seem 
to  have  no  sensitiveness  on  the  matter,  provided  the  station  in  -which  one 
serves  as  a  mere  means  is  sufficiently  dignified.  We  hear  nothing  in  this 
vein  when  they  are  speaking  of  doctors,  lawyers,  professors,  politicians,  and 
others  of  the  higher  classes  of  workers,  though  of  course  these  persons  are, 
on  the  professional  side,  mere  instruments,  mere  things,  just  as  truly  as  the 
common  laborer. 


CHAPTER  XLIV 

THE   PROPERTY  INCOMES   INDESTRUCTIBLE 

In  the  preceding  chapter  we  defended  the  general  principle  or 
ideal  of  distribution  embodied  in  the  present  system,  as  being 
necessary  to  social  welfare,  and,  on  the  whole,  reasonable  and  just. 
But  this  leaves  much  of  our  task  unaccomplished.  The  service- 
value  principle  might  be  all  right,  abstractedly  considered ;  but  it  can 
be  realised  only  under  a  concrete  set  of  conditions.  It  must  work 
itself  out  through  definite  institutions,  legal  prescriptions,  customs, 
economic  laws,  and  so  on.  As  thus  working  itself  out,  is  it  de- 
fensible? The  conditions  in  question,  as  we  know,  are  very  numer- 
ous and  complex.  To  cover  the  whole  matter  thoroughly  is  of 
course  quite  beyond  us.  We  must  content  ourselves  with  some 
consideration  of  the  most  important  points. 

Primary  economic  distribution,  as  we  have  seen,  depends  chiefly 
on  the  kinds  of  shares  or  sources  of  income  which  are  permitted 
and  the  natural  laws  determining  the  volume  of  these  shares.  The 
former  of  these  two  conditions  depends  largely  on  what  kinds  of 
property  are  permitted:  especially  whether  private  persons  may  or 
may  not  own  capital  or  land.  The  latter  is  the  general  principle  of 
distribution  we  have  already  considered.  We  shall  consider  mainly 
the  legitimacy  of  the  shares  or  sources  of  income  by  which  primary 
distribution  is  determined,  more  especially  the  three  property 
incomes. 

As  preliminary  to  the  defense  of  the  existing  system,  I  propose 
to  use  the  present  chapter  to  show  that  the  three  incomes  in  question 
are  indestructible.  They  cannot  be  eliminated ;  and  they  must  af- 
fect the  distribution  of  the  total  social  income  whether  we  believe 
in  them  or  not.  We  may  alter  their  destination,  but  we  cannot 
annihilate  them.  In  making  the  argument  for  this  point,  I  shall 
assume  the  existence  of  a  socialist  order;  since,  if  these  incomes 

524 


XLIV]  PROPERTY  INCOMES  INDESTRUCTIBLE  525 

are  bound  to  exist  under  such  an  order,  few  will  doubt  the  propo- 
sition that  they  will  continue  under  any  order.  We  will  first  take 
up  the  case  of  rent. 

I 
The  Maintenance  of  Rent  Inevitable 

That  rent  would  necessarily  continue  to  exist  under  any  eco- 
nomic order,  supposing  the  condition  necessary  to  create  it — the 
inadequacy  of  the  land  to  meet  the  need  for  it — to  continue,  is  a 
proposition  from  which  there  is  little,  if  any,  dissent.  Economists 
are  apparently  agreed  on  the  point ;  and  even  the  reformers  who 
deny  the  legitimacy  of  a  system  which  permits  private  persons 
to  appropriate  this  income,  usually  admit  that  it  must  exist,  though 
they  would  transfer  it  from  private  landowners  to  the  state.  The 
reason  for  this  unanimity  is  plain.  Rent  is  a  surplus  arising,  not 
through  any  act  of  man,  but  through  the  fact  that  the  natural 
amount  of  land  and  its  capacity  to  assist  in  the  production  of 
commodities  is  so  limited  as  compared  with  the  demand  for  those 
commodities  that  the  latter  necessarily  have  a  value  greater  than 
their  costs  other  than  rent,  and  so  a  surplus  is  created.  By  no 
conceivable  process  can  that  surplus  be  destroyed,  though,  of 
course,  its  destination  can  be  altered. 

Objection. — But  it  is  possible  that  someone  might  be  in- 
clined to  demur  from  this  matter-of-course  settlement  of  the  ques- 
tion. "Whatever  may  be  the  ultimate  condition  necessary  to 
create  rent,"  the  objector  may  say,  "the  condition  immediately  nec- 
essary is  the  existence  of  high  prices  for  land  products,  prices 
higher  than  costs  of  production  on  the  rent-bearing  lands.  But, 
under  socialism,  prices  are  things  to  be  fixed  by  the  government. 
Would  it  not  be  possible,  therefore,  for  government  to  destroy  rent 
by  so  changing  the  prices  of  land  products  as  to  destroy  the  sur- 
plus from  which  it  springs?  Thus,  if  the  government  were  to  fix 
for  each  parcel  of  wheat  a  price  exactly  equal  to  the  cost  of  that 
parcel,  instead  of  having  just  one  price  high  enough  to  equal  the 
marginal  or  greatest  cost,  there  would  be  no  surplus  and  so  no  rent," 


526  PRINCIPLES  OF  ECONOMICS  [XLIV 

Answer. — This  sounds  well ;  but  it  will  not  hold.  The  pro- 
posed policy  would  not  destroy  the  surplus,  but  merely  transfer  it 
from  the  landlord — under  socialism,  the  state — to  consumers  of 
those  parcels  of  wheat  which  were  raised  on  better  lands.1  If  the 
marginal  portion  of  the  wheat  crop  costs  $2  and  continues  to  be 
produced  and  sold,  it  must  be  worth  $2.  But,  if  the  marginal 
portion  is  worth  $2,  the  other  portions  must  also  be  worth  $2,  even 
those  which  cost  only  50  cents  a  bushel.  .Hence,  the  government 
which  should  charge  a  price  of  50  cents  for  wheat  which  cost  only 
50  cents,  would,  in  effect,  make  to  the  buyer  of  that  wheat  a  present 
of  $1.50,  that  is,  would  make  him  a  present  of  the  rent  on  the  land 
from  which  his  wheat  came.  There  can  be  no  doubt,  then,  as  to 
the  soundness  of  the  common  doctrine  that  rent  must  exist  under 
any  economic  order  as  cm  income  divided  in  some  way  among  the 
citizens.2 

II 
The  Continued  Existence  of  Interest  Inevitable 

The  contention  that,  under  socialism  and  so  under  any  system, 
interest  must  continue  to  exist  as  an  income  to  be  enjoyed  by  some 
person  or  persons, — this  contention  has  not  been  so  generally  ac- 
cepted as  the  analogous  one  with  respect  to  rent;  but  it  seems  no 
less  certainly  true.  Interest  represents  a  real  advantage,  a  real 
service,  derived  from  the  power  to  wait,  which  advantage  or  service 
has  marginal  significance  or  importance  because  the  supply  is  not 
sufficient  to  satisfy  all  needs  for  this  service,  and,  having  marginal 
significance,  therefore  has  value.  This  being  true,  only  those 
products  which  had  a  marginal  significance  great  enough  to  justify 
their  having  a  value  which  included  an  allowance  for  interest — the 

1  The  share  going  to  each  of  these  consumers  would,  of  course,  vary 
with  the  goodness  of  the  particular  piece  of  land  on  which  their  parcel  of 
wheat  was  raised. 

a  Most  advocates  of  socialism  would  probably  favor  maintaining  one 
price  for  wheat  and  having  the  state  absorb  the  resulting  rent.  It  is  not 
unlikely,  however,  that  a  socialist  government,  which  would  almost  of 
necessity  be  democratic,  would  manipulate  prices  somewhat  in  order  to  show 
special  favor  to  the  consumers  having  smaller  incomes, — supposing  such  a 
state  to  permit  income  differences. 


XLIV]  PROPERTY  INCOMES  INDESTRUCTIBLE  527 

value  of  waiting — could  legitimately  be  produced.  That  is,  so  long 
as  the  condition  causing  interest — the  inadequacy  of  the  supply  of 
waiting-power  to  satisfy  all  the  need  for  that  waiting  power — con- 
tinued to  exist,3  interest  would  continue  to  exist.  It  might  be 
hidden,  it  might  be  consciously  transferred  from  the  owner  of  the 
waiting  power  to  some  one  else,  it  might  be  ignored;  but  it  could 
not  be  eliminated.  Some  person  or  persons  would  necessarily  en- 
joy it. 

But  possibly  someone  might  bring  forward  an  objection  analo- 
gous to  that  remarked  on  in  the  case  of  rent.  If  interest  under 
socialism  would  be  implicit  in  the  prices  of  commodities,  could  not 
the  government  destroy  it  altogether  through  its  control  over  the 
fixing  of  prices?  Thus,  if  the  prices  of  products  were  lowered  so 
as  to  cover  only  the  costs  other  than  interest  there  would  be  none 
of  this  interest  implicit  in  prices.  Quite  true,  but  not  germane. 
It  would  not  be  in  the  price,  but  it  would  still  be  in  the  value. 
Consumers  would  enjoy  advantages  for  which  they  had  not  paid, 
that  is,  they  would  be  the  recipients  of  the  particular  income  under 
consideration,  interest.  Further,  the  plan  would  involve  much  dis- 
crimination in  the  way  in  which  this  income  was  distributed  among 
consumers.  Those  persons  calling  for  goods  in  the  production 
of  which  waiting  plays  a  large  part  would  get  the  lion's  share  of 
the  interest  income,  the  rest  would  get  little  or  none.  Thus,  the 
plan  proposed  for  eliminating  interest  would  merely  transfer  it 
from  the  state  to  specially  favored  consumers. 

Ill 
The  Maintenance  of  Profit  Inevitable 

That  profit  must  continue  to  exist  under  any  economic  order  is 
somewhat  less  certain  than  the  analogous  proposition  with  respect 
to  rent  and  interest.  Some  types  of  profit  now  familiar  would 

3  We  are  not  here  concerned  with  the  question  whether  the  situation 
which  now  insures  the  existence  of  interest  would  continue,  but  whether, 
even  with  that  situation  continuing,  interest  would  necessarily  continue, — 
whether,  in  other  words,  interest  could  be  eliminated  by  some  arbitrary 
change  in  the  system  or  in  its  management?  The  answer  is  an  emphatic 
negative. 


PRINCIPLES  OF  ECONOMICS  [XLIV 

probably  disappear  altogether.  Further,  the  most  important  con- 
stituent of  profit,  the  one  growing  out  of  risk,  would  be  greatly 
diminished  in  amount,  and  what  remained  would  in  large  measure 
be  transformed  into  other  types  of  income.  As  a  result,  the  total 
of  what  may  be  called  profit  in  the  strict  sense  would  be  much  di- 
minished. Nevertheless,  the  share  now  called  profit  would  have 
its  counterpart  even  under  socialism,  and,  though  a  portion  of  this 
would  be  transformed  into  other  types  of  income,  there  wottld 
remain  a  portion  which  retained  its  own  distinctive  character. 

The  argument  for  this  contention  is  substantially  the  same  as 
in  the  preceding  cases.  Profit  corresponds  to  a  service  which  must 
be  performed  if  production  is  to  go  on  at  all.  If  we  are  to  have 
meat  or  clothes  or  shelter,  someone  must  assume  the  responsibility 
of  producing  these, — must  use  up  his  goods  in  the  venture,  accept- 
ing, in  place  of  those  goods,  the  resulting  product.  This  function 
might  be  performed  by  the  government,  as  under  socialism,  instead 
of  by  private  persons,  as  at  present.  But  performed  by  someone 
it  must  be.  Further,  the  power  to  perform  this  function  must  ob- 
viously depend  on  the  possession  of  surplus  wealth,  capital,  and 
so  must  be  limited  in  amount.  No  one  surely  would  claim  that  our 
wealth  could  ever  be  so  great  that  we  could  afford  to  undertake 
the  production  of  anything  men  might  desire,  however  great  the 
risks  of  failure.  There  would  always  be  wants  clamoring  for  at- 
tention, provision  for  which  would  be  impossible  because,  with  our 
limited  resources,  we  could  not  afford  to  take  the  chances.  That 
is,  the  power  to  assume  the  responsibility  of  production  would 
have  extra-marginal  significance  and  so  would  have  value.  In  con- 
sequence, if  the  production  of  one  of  two  given  commodities  in- 
volved greater  risk  than  the  other,  though  their  costs  in  other 
items  were  the  same,  the  one  to  which  the  greater  risk  attached 
would  need  to  have  more  value  than  the  other  to  justify  its  pro- 
duction instead  of  the  other.  In  other  words,  there  must  be  an 
element  in  the  value  of  any  product  corresponding  to,  representing, 
the  risk  taken  in  its  production.  That  element  is  the  real  profit, 
implicit  profit  we  may  call  it.  As  a  real  value  the  presence  of 
which  is  made  necessary  by  the  conditions  of  the  case,  its  elimina- 
tion is  impossible,  if  production  is  conducted  as  it  should  be,  though 


XLIV]  PROPERTY  INCOMES  INDESTRUCTIBLE  529 

its  destination  can  be  changed.  Thus,  as  in  previous  cases,  we 
might  omit  from  the  selling  price  of  a  given  commodity  the  part 
which  would  correspond  to  the  profit  element  just  described,  and 
it  seems  probable  that  many  advocates  of  socialism  would  favor 
such  a  procedure.  In  doing  this,  however,  we  should  not  be  de- 
stroying profit,  but  only  making  a  present  of  that  profit  to  the 
consumers  of  the  particular  product  in  question. 

The  above  argument  shows  that,  even  under  socialism,  there 
would  necessarily  exist  an  income  corresponding  in  a  general  way 
to  what  is  profit  in  the  present  order.  Under  socialism,  however, 
as  was  indicated  at  the  outset,  a  considerable  portion  of  this  par- 
ticular income  would  naturally  be  transformed  into  the  other  types 
previously  considered,  namely :  wages,  rent,  and  interest.  The 
reason  is  as  follows:  Since,  under  socialism,  the  state  would  be 
the  sole  entrepreneur,  all  losses  of  whatever  character  would  im- 
mediately fall  on  the  state.  That  is,  the  existence  of  such  losses 
would  merely  mean  that  the  total  outlay  of  the  sole  producer  in 
carrying  on  the  industries  of  the  community — his  outlay  in  labor, 
natural  resources,  and  waiting-power — had  been  made  just  so  much 
greater  than  it  would  have  been  if  the  losses  had  not  occurred. 
Doubtless,  there  would  necessarily  be  a  value,  and  so  an  income, 
representing  this  excess  of  cost.  But  such  value  and  such  income 
would  be  assignable,  not  to  some  new  type  of  income,  but  to  one  or 
more  of  those  previously  considered :  wages,  rent,  or  interest. 

We  have  argued  in  the  last  paragraph  that,  though  the  income 
which  now  appears  as  profit  would  largely  survive  under  socialism, 
it  would  after  all  survive,  not  as  a  distinct  type,  but  rather  as  an 
addition  to  wages,  rent,  and  interest.  .  To  this,  however,  it  ought 
to  be  added  that  there  would  probably  remain  under  socialism  a 
residuum  of  profit  in  the  strict  sense,  an  income  not  capable  of  as- 
signment to  one  of  the  other  three.  The  reason  for  this  is  that, 
in  the  long  run,  the  socialist  state  would  insist  on  making  a  charge 
for  products  sufficiently  in  excess  of  probable  losses  to  insure  com- 
ing out  even  ;  and,  in  doing  this,  the  state  would  take  to  itself  a 
type  of  income  closely  analogous  to  pure  profit  under  the  present 
regime,  and  one  which  could  not  be  brought  under  any  or  all  of 
the  three  other  types. 


CHAPTER  XLV 

THE  PROPERTY  INCOMES  AS  INCOMES  OF 
PRIVATE  OWNERS 

It  has  been  shown  in  the  preceding  chapter  that  rent,  interest, 
and  even  profit,  in  some  degree,  are  bound  to  be  present  under  any 
economic  order  as  incomes  enjoyed  by  someone.  This  quite  ob- 
viously does  not  prove  that  they  can  legitimately  be  assigned  to 
the  classes  of  persons  now  receiving  them.  It  does  not  even  con- 
tribute any  definite  argument  in  support  of  such  a  contention. 
Nevertheless,  the  time  spent  establishing  this  point  does  not  seem 
to  me  to  have  been  wasted.  In  the  first  place,  this  aspect  of  the 
matter  greatly  impairs  the  force  of  a  certain  method  of  attacking 
the  legitimacy  of  the  present  assignment  of  the  incomes  in  question 
which  has  had  much  vogue  in  our  day.  That  method  consists  in 
representing  all  economic  institutions  and  arrangements  as  tempo- 
rary, provisional,  almost  accidental.  Capital  itself,  and  of  course 
the  incomes  springing  from  it,  are  "historic  categories."  That  is, 
they  have  no  roots  in  the  very  nature  of  things — they  have  not 
always  existed — they  are  the  product  of  special,  social,  or  legal 
arrangements.  Such  an  account  of  the  matter  does  not,  of  course, 
really  constitute  an  argument  against  the  present  treatment  of 
these  incomes ;  but  it  has  a  sort  of  dissolving  effect  on  the  con- 
victions which  have  been  held  on  these  points.  If  capital,  interest, 
and  profit  are  categories  representing  things  altogether  temporary, 
things  invented  and  established  by  man,  it  is  very  easy  to  slip  into 
the  notion  that  the  particular  disposition  of  these  which  obtains  in 
the  present  order  has  no  presumption  in  its  favor,  that  such  dis- 
position is  purely  artificial  and  arbitrary,  can  be  swept  away  with- 
out hesitation  as  having  no  claim  to  serious  consideration.  Against 
such  a  dissolving  doctrine,  this  text  has  tried  to  guard  the  student 
from  the  very  outset.  There  is  nothing  or  next  to  nothing  in  it. 

530 


XLV]  INCOMES  OF  PRIVATE  OWNERS  531 

Capital  is  not  a  historic  category;  interest  is  not;  profit  is  not. 
With  scarcely  a  shade  of  exaggeration,  we  may  say  that  there 
never  was  a  time  in  the  history  of  civilization  when  they  did  not  all 
exist.  They  have  their  roots  in  the  very  nature  of  things,  not  in  the 
artificial  enactments  of  men.  Any  weakening  in  our  support  of 
the  present  system  derived  from  the  opposite  notion  is  unjustified. 
A  second  advantage  to  be  derived  from  the  establishing  of  the 
doctrine  that  the  three  property  incomes  are  indestructible,  cannot 
be  eliminated,  though  their  destination  can  be  altered,  is  that  it 
isolates  sharply  the  real  issue  before  us,  that  is,  the  question  whether 
or  not  tne  private  appropriation  of  these  incomes  is  legitimate.  That 
question  we  must  now  attempt  to  answer. 

Doctrine  Here  Maintained. — The  conclusion  on  this  point 
reached  in  the  following  discussion  is  on  the  whole  favorable  to 
the  present  order.  In  maintaining  that  position,  however,  I  wish 
to  disclaim  most  emphatically  any  intention  of  affirming  that  the 
present  assignment  of  the  incomes  in  question  is  the  only  reasonable 
or  just  one.  There  is  no  room  for  doubt  that,  if  society  should 
come  to  believe  it  expedient  to  abolish  private  ownership  in  land 
and  capital,  and  so  to  abolish  the  private  appropriation  of  the  in- 
comes derivable  from  these  sources,  it  would  be  entirely  justified 
in  carrying  out  such  a  policy.  There  are  no  private  claims  so 
sacred  that  they  can  stand  against  the  claims  of  the  general  wel- 
fare. Again,  I  wish  to  disclaim  any  intention  of  affirming  that  all 
of  the  three  property  incomes  and  all  types  of  each  are  equally 
defensible.  It  is  easier  to  maintain  the  legitimacy  of  some  than 
that  of  others.  It  would  be  easier  to  make  a  case  for  giving  these 
incomes  to  the  state  in  some  cases  than  in  others.  In  contrast  with 
the  more  extreme  claims  for  the  present  order  which  are  sometimes 
made,  what  we  here  contend  for  is  merely  this :  The  present  as- 
signnent  of  the  incomes  in  question  is  not  inherently  unreasonable 
or  unjust:  the  not  uncommon  contention  of  even  moderate  advocates 
of  reform  that  the  private  appropriation  of  any  income  not  derived 
directly  from  personal  exertion  is  something  very  like  robbery,  thor- 
oughly wrong  under  any  condition, — this  contention  is  entirely  un- 
sound. 


532  PRINCIPLES  OF  ECONOMICS  [XLV 

It  may  perhaps  seem  that  a  defense  of  the  present  order  which 
contends  for  no  more  than  the  proposition  just  laid  down,  would 
scarcely  be  worth  while.  If  it  be  admitted  that  the  state  can  with- 
out injustice  take  from  private  persons  the  right  to  receive  the 
incomes  in  question,  we  may  be  quite  sure,  the  objector  might  say, 
that  would-be  reformers  would  in  time  persuade  themselves  that 
there  is  ample  reason  for  adopting  such  a  policy.  Personally,  I 
am  not  in  accord  with  this  view.  It  has  always  seemed  to  me  that 
the  strength  of  the  socialist  movement  largely  consists  in  the  ac- 
ceptance of  a  grossly  unfair  indictment  of  the  present  order.  Men 
honestly  believe  that,  from  the  very  nature  of  present  arrangements, 
the  capitalist,  however  honest  or  benevolent,  cannot  help  exploiting, 
or  robbing,  labor.  The  acceptance  of  such  a  doctrine  makes  the 
masses  "see  red."  Convince  them  that  it  is  an  erroneous  doctrine, 
and  you  will  have  done  much  toward  eliminating  their  desire  for 
a  new  regime.  In  any  case,  you  will  have  diminished  the  intensity 
of  the  emotional  forces  working  for  the  movement,  and  will  have 
thereby  contributed  toward  a  more  temperate  and  reasonable  altera- 
tion of  the  existing  order,  if  altered  it  must  be. 


Criteria  for  Passing  Judgment  on  the  Legitimacy  of  a  Particular 
Assignment  of  the  Property  Incomes 

In  passing  judgment  on  the  legitimacy  or  reasonableness  of  any 
social  institution  or  policy,  it  is  obviously  necessary  to  have  in  mind 
some  standards  or  criteria  of  such  legitimacy.  Doubtless  there  is 
room  for  difference  of  opinion  as  to  the  true  criteria  for  the  case 
before  us;  but  I  shall  assume  with  little  argument  that  the  follow- 
ing propositions  are  fairly  adequate. 

(1)  In  determining  the  proper  destination  of  so  much  of  the 
value  income  as  expresses  the  contribution  of  a  given  factor,  there 
is  a  presumption  in  favor  of  the  person  responsible  for  the  exist- 
ence of  such  factor,  when  such  person  exists. 

(2)  When  no  person  is  responsible  for  the  existence  of  a  given 
factor,  for  example,  in  the  case  of  the  factors  commonly  covered 
by  the  designation,  land,  the  presumption  is  in  favor  of  men  gener- 
ally, or  the  community  as  a  whole. 


XLV]  INCOMES  OF  PRIVATE  OWNERS 

(3)  The  valid  claim  of  any  person  can  be  completely  alienated 
by  that  person  and  completely  acquired  by  another  person  through 
an  act  of  exchange,  sale  and  purchase, — it  being  assumed  that  said 
exchange  was  on  equitable  terms  approved  by  the  state.     Thus,  if 
a  person  catches  a  hundred  fish,  his  claim  to  property  in  those  fish 
because  he  caught  them  ceases  to  have  any  validity  after  he  has 
sold  them. 

(4)  The  state,  as  the  guardian  of  the  welfare  of  all  and  hold- 
ing in  trust  the  residual  claims  of  all  which  grow  out  of  the  contri- 
butions to  production  derived  from  factors  not  appropriable  or  not 
appropriated,  for  example,  the  fund  of  accumulated  knowledge,  the 
protection  of  government,  etc.,  has  the  power  and  right  to  confirm, 
limit,  or  cancel  all  presumptive  claims  as  may  seem  wise,  and  the 
power  to  alienate  its  own  claims.     Thus,  if  it  seems  on  the  whole 
best,   the   state  can  without  injustice  abolish  the   right   of   private 
persons  to  receive  the  interest  income,  even  though  it  be  admitted 
that  such  destination  of  interest  has  presumption  on  its  side.     On 
the   other  hand,   granting  that   the   state,   as   representing  men   in 
general,  has  the  best  presumptive  claim  to  the  rent  income,  still 
the  state  can,  without  wrong,  alienate  that  income  to  private  per- 
sons, if  there  seem  to  be  adequate  grounds  in  expediency  for  such 
procedure. 

Defense  of  These  Criteria. — Since  the  acceptance  of  these 
propositions  would  render  needless  any  prolonged  consideration 
of  the  reasonableness  of  the  individual  incomes,  we  must  take  a 
moment  to  comment  upon  them.  The  first  would  probably  lead  to 
little  controversy,  being  a  widely  accepted  doctrine  of  very  an- 
cient origin,  and  one  favored  by  the  opponents  of  the  present  or- 
der, as  well  as  its  supporters.  As  to  its  general  validity,  there 
would  seem  to  be  no  serious  reason  for  doubt.  To  have  been 
responsible  for  producing  a  thing,  if  it  does  not  create  an  absolute 
claim  to  the  services  or  contributions  of  that  thing,  must  certainly 
create  a  presumptive  claim  of  this  character. 

The  second  proposition  would  seem  equally  certain.  Doubtless 
man's  need  is,  in  some  sense,  the  most  ultimate  ground  of  the  right 
of  property  in  things.  But  this  ground  :.s  common  to  all  men 


534  PRINCIPLES  OF  ECONOMICS  [XLV 

placed  in  the  same  situation ;  and,  in  the  absence  of  any  presump- 
tion in  favor  of  special  persons,  the  state,  as  representing  all,  could 
surely  set  up  the  best  claim. 

The  third  proposition  is  too  evident  to  need  argument.  To 
have  produced  a  thing  could  not  continue  to  be  a  valid  ground  for 
claiming  property  in  that  thing  after  k  had  been  relinquished  in 
legitimate  exchange.  Controversy  might  always  arise  as  to  whether 
the  price  paid  in  the  exchange  had  been  a  fair  one;  but  this  is  a 
matter  for  regulation  by  itself.  It  ought  not  to  be  confused  with 
the  question  of  title  to  the  thing  sold. 

The  fourth  proposition  would  not  receive  so  ready  assent  as  the 
third.  In  fact,  it  would  doubtless  meet  opposition  from  both  con- 
servatives and  radicals.  The  former  would  deny  that  the  state  can 
legitimately  limit  certain  fundamental  property  rights  at  all,  for 
example,  the  right  of  capitalists  to  control  entirely  the  disposal  of 
their  capital.  Radicals,  on  the  other  hand,  would  deny  that  the  state 
could  ever  legitimately  alienate  its  property  rights  in  land  and 
natural  resources.  Nevertheless,  the  proposition,  as  originally  laid 
down,  seems  a  necessary  foundation  for  any  adequate  social  order. 
It  must  always  be  the  right  and  duty  of  the  state  to  establish  and 
maintain  such  social  and  economic  arrangements  as  seem  necessary 
to  secure  the  best  results  for  society  as  a  whole.  If,  then,  the  state 
becomes  convinced  that,  however  natural  and  reasonable  it  may 
be  to  permit  private  property  in  capital  and  the  private  appropria- 
tion of  the  income  thereof,  yet,  everything  taken  into  account,  such 
a  system  works  much  more  evil  than  good,  the  state  must  surely 
be  bound  to  abolish  that  system,  in  spite  of  the  presumptions  in  its 
favor.1  On  the  other  hand,  if  the  state  becomes  convinced  that 
the  best  good  of  all  demands  the  alienation  of  its  claims  on  natural 
resources  to  private  persons,  such  action  is  surely  within  its  sov- 
ereign prerogatives  and  duties. 


1  The.  right  of  private  persons  to  use  any  wealth  to  which  they  have 
a  valid  claim,  in  initiating  and  guiding  industrial  activities,  is  surely  no  mqre 
reasonable  on  its  face  than  the  right  of  the  same  persons  to  use  that  wealth 
in  buying  such  consumption  goods  as  they  may  desire.  Yet  practically  no 
publicist  of  standing  would  deny  that  it  is  within  the  prerogatives  of  the 
state  to  limit  the  latter  right,  and,  in  some  cases,  to  abolish  it  altogether. 


XLV1  INCOMES  OF  PRIVATE  OWNERS  535 


II 

The    Legitimacy    of    a    System    Which    Permits    the    Capital 
Incomes  to  Be  Appropriated  by  Private  Persons 

In  view  of  the  preceding  discussions,  little  more  seems  needed 
to  establish  the  proposition  that  there  is  nothing  inherently  un- 
reasonable in  the  present  destination  of  the  capital  incomes,  that  is, 
their  being  appropriated  by  private  persons;  that,  on  the  contrary, 
such  destination  has  in  its  favor  a  most  evident  presumption.  Cap- 
ital as  capital — the  power  to  wait  and  to  assume  the  responsibility 
of  production — is  a  product  and  one  for  the  existence  of  which 
private  persons  are  commonly  responsible.  In  order  that  it  should 
come  into  existence,  someone  must  produce  an  income  and,  through 
saving  from  that  income,  accumulate  a  surplus.  Nor  is  this  rea- 
soning invalidated  by  the  consideration  that  the  particular  person 
now  enjoying  its  incomes  obtained  that  capital  through  fraud  or 
violence  or  inheritance.  Such  considerations  are  beside  the  issue. 
We  are  here  concerned  only  with  the  reasonableness  of  the  capital 
incomes  per  se.  In  affirming  that  the  private  destination  of  these 
incomes  has  a  presumption  in  its  favor,  because  the  person  receiv- 
ing those  incomes  produced  the  capital  from  which  they  spring, 
we  are  not  called  on  to  defend  such  a  destination  of  profit  and  in- 
terest, when  admittedly  this  reason  was  not  present.  Of  course,  no 
one  contends  that  a  man  who  has  obtained  capital  through  fraud 
or  violence  ought  to  be  permitted  the  enjoyment  of  its  incomes.  As 
to  whether  there  can  be  any  legitimate  bequest  or  inheritance,  opin- 
ion is  not  unanimous.  But,  in  any  case,  the  matter  does  not  con- 
cern us.  In  the  typical  case,  the  capitalist  is  responsible  for  the 
existence  of  the  capital ;  and  the  presumption  is  that,  because  of 
that  fact,  he  has  a  right  to  its  ffuits. 

The  Laborer's  Claim. — But  the  opponents  of  private  profit 
and  interest  would  not  be  content  without  setting  up  some  other 
claimant  over  against  the  capitalist  himself.  A  fairly  complete 
enumeration  of  possibilities  would  perhaps  give  us  three,  as  fol- 
lows:  (i)  the  laborer  who  works  with,  utilizes,  the  capital  in 


536  PRINCIPLES  OF  ECONOMICS  [XLV 

question,  (2)  the  consumer  of  the  particular  commodities  in  the 
production  of  which  the  capital  in  question  is  utilized,  and  (3)  the 
citizen  or  member  of  society  in  general.  The  first  of  these,  as 
everyone  knows,  is  the  favorite  claimant.  The  basis  of  his  claim 
is  the  doctrine  that  laborers  only  contribute  to  the  production  of 
commodities.  I  trust  we  may  safely  assume  that  this  doctrine  has 
been  completely  disposed  of  in  preceding  discussions.  Capital  as 
capital,  not  merely  capital  as  the  embodiment  of  previous  labor  and 
other  factors,  is  a  real  factor  in  production,  makes  a  contribution 
of  its  own  to  the  total  result ;  and  the  importance  of  this  contribution 
is  more  or  less  fully  expressed  in  the  price  paid  therefor.  The 
laborers  who  have  been  engaged  in  utilizing  said  capital  did  not 
make  the  contribution  in  question,  and  have  no  more  claim  on  the 
incomes  expressing  the  importance  of  that  contribution  than  have 
any  other  members  of  the  community. 

The  Consumer's  Claim. — The  case  against  the  second  claim- 
ant, the  consumer  of  the  particular  commodity,  in  the  production 
of  which  the  capital  was  utilized  is  equally  plain.  As  was  ex- 
plained on  page  527,  such  destination  of  the  capital  incomes  could 
be  brought  about  by  omitting  these  elements  from  our  cost  calcu- 
lations when  deciding  what  price  should  be  charged  for  any  given 
product. 

But  against  such  a  policy  two  strong  objections  would  present 
themselves.  First,  there  is  nothing  whatever  in  the  status  of  the 
consumer  as  such  on  which  to  base  a  claim  to  these  shares.  On 
the  contrary,  the  very  nature  of  his  position  naturally  calls  on 
him  to  pay  rather  than  receive.  He  enjoys  the  utilities  derivable 
from  the  product;  he  should  fully  make  good  its  costs.  In  the 
second  place,  distributing  the  incomes  in  question  to  consumers  by 
omitting  profit  and  interest  from  prices  would  necessarily  involve 
a  wholly  baseless  discrimination  among  consumers.  For  waiting 
and  risk  enter  into  the  production  of  different  commodities  in  quite 
different  proportions,  and  these  commodities  enter  into  the  con- 
sumption of  different  citizens  in  quite  different  proportions;  hence, 
some  persons  would  be  large  consumers  of  products  costing  much 
waiting  and  risk,  and  so  would  gain  much  from  the  generosity  of 


XLV]  INCOMES  OF  PRIVATE  OWNERS 


537 


the  state,  while  others  would  consume  but  little  of  such  commodi- 
ties, and  so  would  be  small  gainers  from  this  policy. 

The  Citizen's  Claim. — There,  then,  remains  only  the  third 
possible  rival  to  the  capitalist  as  the  legitimate  claimant  of  interest 
and  profit,  that  is,  the  citizen  in  general.  As  against  the  claims  of 
either  of  the  other  two  rival  claimants,  this  one  of  the  citizen  in 
general  is  surely  the  best.  The  claims  of  the  laborer  and  consumer 
have  no  foundation ;  for  that  of  the  citizen  in  general,  some  very 
slight  basis  may  be  discovered.  The  citizen  in  general  is  the 
residuary  legatee  of  all  rights,  advantages,  for  which  a  truly  legiti- 
mate claimant  cannot  be  found ;  for  he  stands  for  humanity  in 
general,  is  the  inheritor  of  the  knowledge  and  skill  brought  down 
from  the  past,  and  the  maintainer  of  the  political  and  legal  institu- 
tions essential  to  all  economic  life.  Nevertheless,  it  is  surely  little 
short  of  absurd  to  argue  that  the  claim  to  the  capital  incomes  set 
up  by  the  mere  citizen  who  has  had  no  share  in  producing  that 
capital  is  as  good  as  that  of  those  persons  who  are  just  as  much 
citizens  as  himself  and,  in  addition,  have  really  produced  the  capital. 
Surely  the  claims  of  the  latter  have  a  strong  presumption  in  their 
favor,  though,  as  so  often  admitted,  they  may  be  overridden  by 
weighty  considerations  of  public  advantage. 

ILLUSTRATIVE  PROBLEM 

The  medieval  church  attempted  to  eliminate  completely  the  taking  of 
interest,  but  thought  it  right  for  capitalists  to  gain  a  profit  from  the  con- 
duct of  business  enterprises.  Can  you  see  any  reason  why  the  case  for 
profit  would  seem  to  be  better  than  that  for  interest? 

Ill 
The  Legitimacy  of  Rent  as  a  Private  Income 

It  is  manifest  that  the  right  to  receive  rent,  the  income  which 
represents  the  marginal  importance  of  the  contribution  made  by 
the  land,  cannot  be  defended  on  the  ground  brought  forward  in  the 
case  of  the  capitalistic  incomes, — the  ground,  namely,  that  the 
receivers  of  the  income  in  question  are  responsible  for  the  existence 


538  PRINCIPLES  OF  ECONOMICS  [XLV 

of  the  source  from  which  that  income  springs;  for,  broadly  speak- 
ing, land  is  not  producible.  Again,  this  fact  that  land  is  not  pro- 
ducible means  that  the  presumptive  title  to  this  factor  belongs  to 
the  community,  the  state.  It  follows  that  private  persons  can  ob- 
tain a  valid  title,  if  at  all,  only  through  the  grant  of  the  state.  The 
real  question,  therefore,  is  this :  Can  the  state  legitimately  alienate 
its  title  to  the  land,  or,  anyhow,  its  title  to  the  income  of  the  land? 
An  affirmative  answer  to  this  question  seems  inevitable. 

Alienation  and  Social  Expediency. — First,  it  is  scarcely  to 
be  doubted  that  the  state  could  make  such  renunciation  of  its  rights 
on  non-economic  grounds,  grounds  of  political  or  social  expediency. 
Thus,  it  may  be  argued  that  an  almost  indispensable  means  for 
insuring  stability  in  the  social  order  is  the  presence  of  a  consider- 
able class  rendered  peculiarly  interested  in  the  maintenance  o£ 
such  stability,  and  peculiarly  likely  to  develop  the  habits  and  dis- 
positions which  render  it  well  fitted  to  maintain  that  stability;  and 
that  one  of  the  best  methods  of  developing  such  a  class  is  to  es- 
tablish a  system  of  private  property  in  lands  used  for  farming 
purposes.  Such  an  opinion  has  long  been  held  and  has  long  in- 
fluenced powerfully  the  action  of  governments.  Whether  sound 
or  not,  this  opinion  would  seem  to  justify  the  corresponding  action 
on  the  part  of  the  state ;  for  the  state  has  no  choice  except  to  act  in 
accord  with  its  best  judgment  in  trying  to  secure  the  best  good 
of  all. 

ILLUSTRATIVE  PROBLEM 

The  policy  pursued  by  the  leaders  who  reorganized  society  after  the 
dissolution  of  Roman  political  civilization  of  making  huge  grants  of  land 
to  their  chief  subordinates  doubtless  contained  the  seeds  of  many  abuses. 
Nevertheless,  much  is  to  be  said  in  favor  of  the  legitimacy,  almost  the 
necessity,  of  instituting  such  a  policy.  Defend  the  latter  statement. 

Alienation  and  Economic  Services. — But,  again,  it  seems 
plain  that  the  state  could  legitimately  renounce  its  natural  right  to 
the  land  and  its  income,  in  return  for  economic  advantages  or 
services  which,  in  the  opinion  of  the  public,  were  worth  the  price. 


XLV]  INCOMES  OF  PRIVATE  OWNERS 

One  of  the  most  familiar  and  universal  cases  of  this  kind  is  fur- 
nished by  the  practice  prevalent  in  all  ages  of  granting  a  more  or 
less  complete  property  right  in  land  to  persons  who  opened  up, 
cleared,  or  otherwise  brought  into  a  productive  state  lands  hitherto 
unused.  Scarcely  distinguishable  from  this  case  is  one  which  arises 
when  governments  make  grants  of  lands  in  order  to  develop  the 
country  as  a  whole,  swell  its  population,  expand  the  market  for  the 
manufacturing  and  commercial  industries  of  the  older  parts  of  the 
country,  and  so  on. 

Alienation  and  Efficiency. — Another  case  of  alienating  the 
nation's  property  in  the  land  in  exchange  for  supposed  economic 
advantages  appears  when  land  is  granted  to  private  persons  in  or- 
der to  secure  the  highest  efficiency  in  its  utilization.  This  has  played 
no  inconsiderable  part  in  initiating  and  maintaining  the  right  of 
private  property  in  this  fundamental  factor  of  production.  Ex- 
perience is  believed  to  have  shown  that,  in  farming,  ownership  will 
yield  far  better  results  than  any  sort  of  tenancy.  In  this  connection, 
it  is  interesting  to  note  that  advocates  of  socialism  have  in  later 
years  felt  almost  obliged  to  hint  at  excepting  agriculture  from  their 
system  of  universal  undertaking  by  the  government.2  This  notion 
that  the  private  control  of  the  land,  on  the  whole,  works  for  su- 
perior efficiency,  has  been  brought  forward  even  in  the  case  of 
lands  used  as  sites  for  the  manufacturing  and  commercial  industries. 
Not  a  few  advocates  of  a  single  tax  on  land  have  given  up  the  plan 
of  making  this  tax  cover  the  whole  rent,  on  the  ground  that  this 
policy  would  lead  owners  to  relinquish  their  rights  to  the  public,  a 
result  which  would  substitute  expensive  and  inefficient  public  man- 
agement of  these  sites  for  a  private  one  which  is  fairly  free  from 
these  defects. 

Alienation  and  Capital  Burdens. — A  final,  and  even  more 
strictly  economic,  advantage  of  turning  the  land  of  the  community 
over  to  private  ownership  is  found  in  the  fact  that  thereby  the  public 


3  It  was  reported  this  winter  (1921)  that  the  communistic  government  of 
Russia  had  decided  to  release  the  peasantry  in  large  measure  from  the 
operation  of  their  system. 


540  PRINCIPLES  OF  ECONOMICS  [XLV 

escapes  various  burdens  incident  to  occupying  the  position  of  land- 
owner. It  has  already  been  fully  explained  that  the  price-making 
forces  give  to  a  non-producible  income-bearer  such  as  land  a  price 
equal  to  the  capitalization  of  its  income.  It  follows  that  every  per- 
son owning  a  piece  of  income-bearing  land  must  consciously  keep 
invested  in  that  land  a  sum  of  general  value  equal  to  the  amount 
which  at  current  rates  of  interest  would  yield  an  income  equal  to 
the  one  given  off  by  said  land.  In  doing  this,  he  necessarily  makes 
two  sacrifices :  ( i )  foregoing  the  present  control  and  use  of  the 
amount  invested,  and  (2)  taking  the  risk  that,  through  the  decline 
in  the  income  of  said  land,  he  will  suffer  more  or  less  loss  on  the 
capital  sum.  In  the  language  of  the  business  world,  the  land  has  to 
be  "carried."  Now  the  bearing  of  these  two  burdens  of  ownership 
would  doubtless  be  less  onerous  to  the  socialist  state  than  it  is  at 
present  to  private  owners.  But  it  could  not  help  being  present,  par- 
ticularly the  first  of  these.  Circumstances  might  easily  arise  under 
which  it  would  be  greatly  to  the  advantage  of  the  state,  or  anyhow 
would  be  so  considered,  to  exchange  the  right  to  receive  an  endless 
series  of  small  future  incomes  for  the  right  to  have  now  a  lump 
sum  equal  to,  say,  twenty  times  one  of  those  small  incomes.  That, 
under  such  circumstances,  the  state  would  be  justified  in  relinquish- 
ing to  private  persons  the  right  which  naturally  belongs  to  it  as  the 
representative  of  men  generally  seems  incontestable.  Such  a  con- 
clusion follows  inevitably  from  any  doctrine  of  sovereignty:  the 
state  has  the  right  to  do,  ought  to  do,  whatever  it  believes  to  be  on 
the  whole  most  conducive  to  the  general  good. 

Considerations  of  Equity. — As  a  final  comment  of  some 
weight  in  the  situation,  we  may  call  attention  to  a  fact  implicit  in 
what  was  just  said  with  respect  to  the  capitalization  of  the  income 
of  the  land.  This  process  means  that  the  rent  is  in  effect  trans- 
formed into  interest  and  profit, — quasi-interest  and  quasi-profit. 
When  a  system  of  private  property  in  land  has  been  maintained  for 
any  considerable  time,  persons  can  put  themselves  into  the  position  of 
rent-receivers  only  by  parting  with  an  amount  of  money  capitr1 
equal  to  the  value  of  the  property  in  question.  It  follows  that, 
from  the  standpoint  of  abstract  justice,  if  only  these  persons  are 


XLV]  INCOMES  OF  PRIVATE  OWNERS  54! 

taken  into  account,  the  rent  received  is  as  truly  justified  as  interest 
and  profit  received  from  any  ordinary  capital.  The  public  interest 
may  sometimes  require  a  complete  disregard  of  the  claims  thus 
created.  But  this  is  true  of  all  rights.  Until  such  a  situation 
arises,  the  presumption  holds  that  what  the  citizen  has  obtained 
through  exchange  for  an  equivalent  sum  of  general  wealth  he  has 
a  valid  right  to  enjoy. 

IV 
Further  Modifying  Conditions  of  Actual  Life 

In  the  preceding  defense  of  the  existing  system  of  distribution, 
we  began  by  arguing  for  the  general  reasonableness  of  the  principle 
which  is  supposed  to  be  realized  more  or  less  fully  in  that  system, — 
that  is,  the  principle  that  each  tends  to  get  an  income  correspond- 
ing to  the  social  value  of  his  services — his  contribution  to  our  eco- 
nomic life.  We  next  undertook  to  maintain  the  thesis  that  said 
principle  is  still  reasonable  even  under  the  specific  conditions  which 
enter  into  the  actual  economic  order.  In  doing  this,  however,  we 
have  merely  taken  into  account  one  set  of  conditions,  namely,  that 
legal  system  which  permits  private  property  in  land  and  capital 
arid  so  recognizes  the  contribution  of  these  factors  as  being  virtu- 
ally contributions  of  private  persons,  and  which,  therefore,  recog- 
nizes rent,  interest,  and  profits  as  legitimate  sources  of  private 
income. 

If  we  were  trying  to  make  a  truly  complete  critique  of  the  ex- 
isting system  of  distribution,  we  should  be  compelled  to  test  the 
legitimacy  of  our  service-value  principle  in  the  presence,  of  many 
other  modifying  conditions.  To  carry  out  this  test,  however,  would 
take  us  far  beyond  the  scope  of  the  present  volume.  We  shall 
therefore  content  ourselves  with  mentioning  some  of  these  condi- 
tions, without  attempting  more  than  the  briefest  comment. 

Defects  of  Human  Nature. — In  the  present  chapter  we  have 
merely  attempted  to  argue  for  the  general,  abstract  legitimacy  of 
interest,  profits,  and  rent  as  private  shares,  haznng  no  regard  to  the 
weaknesses  of  human  nature,  Taking  those  well  known  weak- 


542  PRINCIPLES  OF  ECONOMICS  [XLV 

nesses  into  account,  can  the  shares  named  still  legitimately  go  to 
private  persons  ?  We  recognize  this  question  as  a  really  serious  one. 
We  see  much  force  in  the  contention  that,  however  reasonable  it 
may  be  on  general  principles  to  permit  the  private  ownership  of 
capital  and  land  and  the  private  undertaking  of  industry,  the  evils 
which  inevitably  results  from  such  a  policy  in  the  actual  working  of 
things  make  its  continuance  impossible  of  justification.  Still,  in 
view  of  the  great  superiority,  in  other  respects,  of  private,  to  public, 
ownership,  and  in  view  of  the  fact  that  its  worst  evils  can  be 
gradually  removed  without  overturning  the  system,  we  believe  that 
the  system  of  private  ownership  should  be  maintained.  At  the 
same  time,  however,  regulation  of  private  initiative  should  un- 
doubtedly be  carried  much  further  than  it  has  been,  limitations  of 
the  property  right  should  be  increased,  and  at  some  points,  how 
many  and  what  only  experience  will  show,  public  ownership  and 
initiative  should  be  substituted  for  private. 

Rights  of  Inheritance  and  Bequest. — A  second  supplemental 
question  of  much  importance  is  whether  the  present  system  is  justi- 
fied in  permitting  private  individuals  to  acquire  possessions  through 
inheritance  or  bequest.  Personally,  I  am  disposed  to  answer  this 
question  in  the  affirmative  but  only  with  very  emphatic  qualifica- 
tions. I  would  greatly  reduce  these  rights  both  directly  by  legisla- 
tion and  indirectly  by  a  taxation  which,  for  the  excess  of  larger 
estates  over  a  certain  minimum,  would  amount  to  practical  con- 
fiscation. 

Social  Opportunities. — Still  another  question  is  whether  law 
should  permit  private  persons  to  enjoy  the  extraordinary  profits 
which  flow  from  the  exploitation  of  natural  resources,  public  fran- 
chises, consolidations,  etc.  We  can  only  say  in  this  limited  space 
that  such  permission  is  of  very  doubtful  justice,  and  should  at  least 
be  carefully  guarded. 

Secondary  Distribution. — Finally,  how  far  can  society  afford 
to  modify  the  primary  distribution  of  property  and  income  through 
a  secondary  distribution  effected  by  taxation?  It  would  seem 


XLV]  INCOMES  OF  PRIVATE  OWNERS  543 

that,  if  the  dominance  of  the  present  principle  of  distribution — to 
each  in  accord  with  the  value  of  his  service — is  necessary  to  insure 
the  proper  conduct  of  economic  affairs,  we  should  spoil  everything 
by  arbitrarily  contravening  the  working  of  that  principle,  even 
though  we  do  this  after  distribution  in  accord  with  the  principle 
has  once  been  effected.  For  what  interest  would  a  man  have  in 
earning  ten  times  as  much  as  his  fellows,  if  he  is  to  be  reduced  to 
their  level  by  taxation?  Doubtless,  if  it  were  to  go  so  far  as  this,  he 
would  have  no  interest  in  seeking  the  better  income.  But,  on  the 
other  hand,  there  can  be  no  doubt  that  a  tax  much  heavier  than 
that  levied  on  his  poorer  neighbor  would  not  influence  in  any 
material  degree  his  economic  efficiency.  The  whole  problem  is  one 
of  degrees.  Its  solution  probably  can  be  reached  only  through  ex- 
periment, and  for  that  we  shall  have  to  wait. 

ILLUSTRATIVE  PROBLEM 

The  chief  justification  for  the  retention  of  a  system  which  permits 
private  ownership  in  property  and  private  receipt  of  property  incomes  is 
based,  in  the  last  analysis,  on  the  ground  of  expediency.  Such  a  system 
works  fairly  well.  Practically,  the  individuals  in  whom  are  vested  the 
legal  titles  to  property  and  to  the  incomes  derived  from  them,  act  as 
stewards  for  society  in  the  care  and  utilization  of  these  properties,  and 
in  the  disposition  of  a  large  part  of  the  incomes  derived  from  them. 
Argue  in  support  of  the  thesis  contained  in  the  second  sentence. 


CRITIQUE  OF  THE  PROCESS  WHEREBY  PRODUC- 
TION IS  REGULATED 

The  chief  characteristics  which  we  can  reasonably  require  in 
a  productive  system  are :  •  ( I )  that  the  right  things  shall  be  pro- 
duced; (2)  that  the  quantity  of  product  shall  be  reasonably  large; 

(3)  that  the   quality  of   product   shall   be   reasonably   good;   and 

(4)  that  these  results  shall  be  realized  as   continuously   as  pos- 
sible,— in  other  words,  that  production  as  a  whole  shall  be  as  free 
as  possible  from  marked  irregularities.     In  the  present  chapter  we 
take  up  the  first  of  these  requirements, — that  the  right  thing  shall 
be  produced,  or  The  Regulation  of  Production. 

It  has  by  this  time  become  a  commonplace  that,  under  the  pres- 
ent order,  the  selection  of  what  shall  be  produced  is  almost  entirely 
effected  through  freely-determined  prices.  Now,  as  the  earlier 
economists  taught,  if  the  present  system  could  realize  fully  the  con- 
ditions which  are  assumed  as  fundamental  to  it,  this  regulative 
mechanism  would  probably  be  an  almost  perfect  one.  The  spon- 
taneous working  of  free  competition  would  result  in  prices  which 
would  insure  production  of  the  things  called  for  by  the  general 
advantage, — the  things  which  a  wise  dictator  dealing  with  the  same 
conditions  would  think  it  expedient  to  produce.  Further,  the 
earlier  economists  commonly  believed  that,  even  under  the  condi- 
tions actually  existing,  price-guided  production  in  the  main  worked 
out  results  as  near  the  ideal  as  could  reasonably  be  expected. 

In  our  day,  this  opinion  is  probably  still  held  by  the  majority  of 
economists.  But  a  not  inconsiderable  minority  take  radical  ground 
on  the  other  side.  A  few  even  insist  in  unqualified  terms  that  there 
is  no  truth  whatever  in  the  older  doctrine,  that  there  is  not  even  a 
tendency  for  production  to  follow  the  channels  which  social  or 
general  advantage  would  dictate.  In  view  of  this  disagreement,  a 

544 


XLVI]  CRITIQUE  OF  PRODUCTION  REGULATION 

careful  and  rather  full  treatment  of  the  matter  seems  called  for. 
We  ask,  then :  Do  the  principles  governing  price  promise  to  secure 
a  reasonable  guidance  of  productive  activity f  In  answering  this 
question,  we  will  first  comment  briefly  on  the  standard  to  be  set  up 
in  judging  whether  a  particular  guidance  of  production  is  reason- 
able ;  after  which  we  will  pass  in  review  the  leading  principles  of 
price,  and  try  to  determine  the  fitness  of  each  to  meet  this  test. 


What  Is  a  Reasonable  Regulation  of  Production? 

The  answer  to  this  question  has  already  been  made  in  introduc- 
ing our  critique  of  Distribution  in  Chapter  XLII.  The  general  ob- 
ject of  an  economic  order  of  any  kind  is  to  secure  the  satisfaction  of 
human  wants  in  so  far  as  this  depends  on  economic  goods.  Just 
what  wants  shall  be  included  under  this  general  category,  and  the 
comparative  order  of  their  importance  as  between  different  persons, 
are  determined  by  the  system  of  distribution.  It  follows  that 
production,  like  all  other  economic  processes,  should  be  so  regulated 
as  to  correspond  to  the  system  of  distribution, — to  provide  for  the 
satisfaction  of  wants  according  to  the  scale  which  is  in  effect  em- 
bodied in  the  system  of  distribution.  This  means  that,  broadly 
speaking,  no  wants  are  recognized  as  social  wants  except  those  of 
persons  having  incomes  under  the  existing  system  of  distribution, 
and  that  the  wants  of  different  persons  have  a  social  importance 
corresponding  to  the  size  of  their  incomes.  Finally,  it  means  that 
the  general  demand  schedules  made  up  of  the  different  individual 
demand  schedules,  composite  as  they  are,  express  the  social  im- 
portances of  wants. 

Objections:  Absolute  Magnitude. — The  objection  to  this 
method  of  rating  wants,  that  it  does  not  rate  them  according  to 
their  real  or  absolute  magnitude,  has  been  answered  directly  or 
by  implication  in  the  argument  for  the  general  reasonableness  of  the 
present  system.  The  social  magnitude  of  wants  is  the  only  one  in 
which  society  at  large  is  interested ;  and  the  social  magnitude  of 
wants  is  bv  no  means  identical  with  their  absolute  magnitude.  In 


546  PRINCIPLES  OF  ECONOMICS  [XLVI 

the  spring  of  1918,  the  wants  of  a  French  private  soldier  may  have 
had  as  great  absolute  magnitude  as  those  of  Marshal  Foch;  but, 
quite  obviously,  they  had  much  less  social  magnitude. 

Circular  Reasoning. — Another  and  somewhat  more  serious 
objection  to  the  doctrine  before  us  is  that,  taken  as  a  whole,  it  in- 
volves circular  reasoning.  "On  the  one  hand,  letting  ordinary  de- 
mand prices — mere  composites  of  heterogeneous  individual  schedules 
— represent  the  social  importance  of  wants  is  said  to  be  legitimate, 
because  this  is  the  necessary  complement  of  the  system  of  distribu- 
tion. On  the  other  hand,  the  system  of  distribution  is  said  to  be 
legitimate,  because  it  gives  each  person  what  his  services  are  worth 
as  indicated  by  the  general  demand  schedule.  The  system  of  dis- 
tribution establishes  the  legitimacy  of  the  demand  schedules;  the 
demand  schedules  establish  the  legitimacy  of  the  system  of  dis- 
tribution." 

Now,  this  sounds  plausible ;  but  it  will  not,  after  all,  bear  exami- 
nation. It  would  be  true  only  on  condition  that  all  large  incomes 
were  obtained  by  catering  to  the  demand  of  persons  of  large  incomes 
only.  We  should  then  be  defending  the  power  of  a  particular  group 
of  persons  to  influence  unduly  the  course  of  production,  on  the 
ground  that  this  was  the  necessary  complement  of  a  system  of  dis- 
tribution which  gave  persons  of  that  group  large  incomes  because 
those  persons  supplied  services  which  were  accounted  very  impor- 
tant, because  persons  of  that  same  group,  having  large  incomes,  were 
able  to  rate  those  services  highly.  But  I  hardly  need  say  that  no 
such  relation  exists  between  large  incomes  and  their  source.  The 
great  majority  of  persons  in  receipt  of  large  incomes  get  those  in- 
comes from  industries  which  cater,  not  to  the  demands  of  large- 
income  persons  only,  but  rather  to  the  demands  of  all  classes.  The 
circularity  complained  of  is  not,  therefore,  characteristic  of  the  ac- 
cepted reasoning,  but  only  of  special  cases  to  which  that  reasoning 
may  be  applied. 

Recapitulation. — In  order  to  emphasize  the  entire  course  of 
reasoning  on  this  matter,  let  us  recapitulate  it  in  a  series  of  proposi- 
tions as  follows : 


XLVIJ  CRITIQUE  OF  PRODUCTION  REGULATION  547 

(1)  The  kind  of  importance  in  respect  to  wants  with  which 
society  is  really  concerned  and  which,  in  the  interest  of  the  social 
welfare,  should  be  treated  as  the  proper  guide  of  economic  action 
is  social  importance.    If  this  is  not  identical  with  individual  or  abso- 
lute importance,  the  latter  must  yield. 

(2)  The  social  importance  of  the  wants  "of  different  individuals 
depends,  not  primarily  on  the  absolute  magnitude  of  those  wants, 
but  on  the  relative  importance  of  the  different  social  ends  the  attain- 
ment of  which  may  be  conditioned  on  the  satisfying  of  those  wants, 
and  the  degree  to  which  their  attainment  is  so  conditioned.1 

(3)  One  important  way  in  which  the  attainment  of  social  ends 
is  conditioned  on  the  satisfying  of  individual  wants  is  found  in  the 
fact  that  the  getting  of  efficient  service  from  individuals  is  dependent 
on  providing  for  the  satisfaction  of  their  wants  in  certain  propor- 
tions.    If  we  do  not  provide  for  their  wants  in  these  proportions, 
we  do  not  get  the  service  called  for. 

(4)  On  account  of  the  great  inequalities  in  human  capacity  and 
the  consequent  inequalities  in  the  importance  of  the  services  different 
men  can  render,  it  is  practically  indispensable  that  this  satisfying 
of  their  wants  on  which  their  efficient  service  is  conditioned,  should 
have  some  reference  to  the  importance  of  those  services,  and  so  this 
satisfying  of  wants  should  be  unequal  as  between  different  persons. 

(5)  Under  the  present  system,  society  elects  to  attain  the  end 
by  making  the  money  incomes  of  different  individuals  unequal  and 
roughly  adjusted  to  the  importance  of  their  services, — leaving  those 
individuals  themselves  to  put  a  rating  on  the  relative  importance  of 
wants. 

(6)  In  doing  this,  society  necessarily  recognizes  these  indi- 
vidual ratings  of  the  importance  of  wants  as  social  ratings,  express- 
ing the  true,  though  indirect,  social  importance  of  those  wants. 

(7)  It  thus  follows  that,  broadly  speaking,  the  demand  prices 
of  the  ordinary  demand  schedules  are,  in  a  very  real  sense,  expres- 
sions of  the  social  importance  of  the  wants  involved. 

Qualifications. — Having  so  roundly  emphasized  the  point  that 
the  demand  schedules  resulting  under  the  existing  system  of  distri- 

1  See  Note  10,  Appendix. 


548  PRINCIPLES  OF  ECONOMICS  [XLVI 

bution  represent  broadly  comparative  social  wants,  let  me  once  more 
remind  the  reader  that  this  must  be  qualified  if  it  is  to  be  an  entirely 
true  account  of  the  matter.  At  several  points,  other  indices  of  the 
true  social  importance  of  wants  are  needed.  The  state  must  find 
other  criteria  when  the  wants  of  the  group  as  a  whole  come  into 
conflict  with  those  of  individuals ;  when  the  needs  of  future  genera- 
tions conflict  with  those  of  the  present ;  and  when  the  most  funda- 
mental needs  of  many  individuals  are  opposed  to  the  trifling  needs 
of  the  few.  In  short,  the  general  position  here  taken,  that  we  must 
accept  the  demand  prices  of  individuals  as  indices  of  social  impor- 
tance is  in  general  perfectly  sound;  but,  as  in  other  cases,  it  is  not 
always  valid :  these  indices  must  at  times  give  place  to  others  better 
adapted  for  the  particular  case  in  hand. 

ILLUSTRATIVE  PROBLEM 

It  may  be  socially  more  important  that  a  great  executive  enjov  a 
week's  outing  on  which  he  is  willing  to  spend  $1,000,  than  that  a  common 
laborer  get  a  winter's  supply  of  coal  on  which  he  can  afford  to  spend, 
say,  $150.  Defend  that  statement. 

II 

Are  Prices  Which  Are  Determined  Under  the  Law  of  Single 
Price  Proper  Guides  of  Production? 

Having  now  so  definite  a  criterion  as  to  what  constitutes  a  proper 
regulation  of  production,  our  review  of  the  different  laws  of  price 
which  participate  in  this  process  ought  to  prove  a  relatively  easy 
task.  First,  then,  we  ask :  Is  the  law  of  single  price  a  suitable 
element  in  the  mechanism  which  has  the  function  of  regulating 
economic  production?  The  answer  is  surely  an  affirmative  one. 
First,  it  is  manifest  on  a  little  reflection  that  singleness  of  price  is 
necessary  to  the  realization  of  the  system  of  distribution  authorized 
by  society.  If  incomes  were  equal,  while  the  same  goods  had  dif- 
ferent prices,  the  equality  of  incomes  would  be  defeated  by  indirec- 
tion. One  man  could  not  get  as  much  real  income  as  another  man 
though  their  money  incomes  were  equal.  On  the  other  hand,  if 
society  decrees  inequality  of  income,  singleness  of  price  is  necessary 


XLVI]  CRITIQUE  OF  PRODUCTION  REGULATION  549 

both  from  the  standpoint  of  the  man  of  small  income  and  from  that 
of  the  man  of  large  income.  If  prices  were  lower  to  the  rich  man 
this  would  increase  the  inequality,  make  it  greater  than  the  social 
intention.  If  prices  were  higher  to  the  rich  man  this  would  neu- 
tralize the  superiority  of  his  income. 

But  there  is  another  reason  and  if  anything  a  more  fundamental 
one  why  the  law  of  single  price  is  a  proper  element  in  the  system 
guiding  production.  It  is  logically  essential  to  having  price  act  as  a 
guide  at  all.  Guidance,  like  sovereignty,  must  be  indivisible.  One 
price  for  each  product  or  each  factor  can  guide  us  in  the  production 
of  that  product  or  the  use  of  that  factor;  but  many  prices  for  each 
could  not  guide  at  all.  Thus,  if  the  relation  of  supply  and  demand 
is  such  that  common  sand  is  at  the  margin  worth  50  cents  while 
moulding  sand  is  worth  $i,  these  prices  can  perform  their  function 
in  showing  us  that  common  sand  can  properly  be  put  to  uses  as  low 
as  50  cents  while  moulding  sand  must  be  reserved  for  uses  rated  as 
high  as  $i,  only  on  condition  that  the  one  price  of  common  sand  is 
50  cents  and  the  one  price  of  moulding  sand  is  $i.  If  at  the  same 
time  common  sand  has  prices  of  50  cents,  75  cents,  $i,  $1.25,  $1.50, 
and  so  on,  we  should  have  no  guidance  whatever  from  this  source, — 
prices  would  have  no  significance  as  respects  the  importance  of  the 
things  involved. 

Ill 

Are  Prices  Which  Are  Influenced  by  Demand  Prices  and  the 
Forces  Behind  Them  Proper  Guides  of  Production? 

We  have  seen  that  the  law  of  single  price  constitutes  not  only  a 
legitimate,  but  also  a  necessary,  element  in  an  economic  order  which 
entrusts  the  regulation  of  production  to  freely  determined  prices. 
What  now  is  to  be  said  of  those  principles  zvJiich  impute  to  demand 
prices  and  the  forces  behind  them,  significance,  utility,  a  share  in  the 
fixing  of  actual  prices,  and  therefore  in  the  regulation  of  produc- 
tion? Do  these  constitute  a  legitimate  element  in  the  regulative 
mechanism  ?  Is  it  reasonable  that  actual  prices  which  approximately 
equal  demand  prices,  and  approximately  express  marginal  utilities 
or  significances  should  participate  in  the  guidance  of  production? 


550  PRINCIPLES  OF  ECONOMICS  [XLVI 

The  Case  of  the  Individual. — In  giving  an  affirmative  answer, 
the  majority  of  economists  have  probably  had  in  mind  the  analogy 
of  the  individual  guiding  his  own  economic  life  in  accord  with  his 
individual  demand  schedules.  With  respect  to  the  reasonableness  of 
his  conduct  in  doing  this,  there  has  been  no  serious  difference  of 
opinion.  Those  schedules  consist  of  money  expressions  of  utility  or 
significance  for  different  commodities.  These  money  expressions 
are  fairly  accurate  indices  of  the  comparative  importance  to  the  indi- 
vidual of  the  utilities  in  question,  and  so  of  the  goods  which  yield 
the  utilities.  And  the  function  of  such  money  expressions  of  utilities 
or  significances  is  to  guide  the  individual  in  the  rational  utilization  of 
his  income  or  resources  from  which  to  secure  an  income.  Speaking 
broadly,  each  person  should,  as  far  as  possible,  employ  his  income 
of  purchasing  power  in  such  a  way  that  the  marginal  utilities  derived 
from  equal  portions  of  that  income  would  be  equal;  and,  when  this 
is  not  possible,  should  employ  said  income  in  such  a  way  that  utilities 
or  significances  of  higher  rank  would  never  be  sacrificed  for  utilities 
or  significances  of  lower  rank.  The  practical  wisdom  of  such  a  rule 
of  conduct  is  plain,  for  it  surely  is  the  part  of  good  sense  to  provide 
for  the  satisfaction  of  our  wants  in  proportion  to  their  importance. 

The  Case  of  Society. — Is  there  a  true  analogy  between  this 
case  of  the  individual  and  that  of  society  as  a  whole?  Is  there  a  rule 
analogous  to  that  just  laid  down  for  the  individual  which  can  rea- 
sonably be  applied  to  society  as  a  whole?  Is  it  reasonable  that  we 
should,  generally  speaking,  so  use  our  resources  that  marginal 
utilities,  as  these  appear  to  be  when  judged  by  the  general  demand 
schedules,  shall  be  substantially  equal  all  along  the  line  ?  That  such 
a  rule  for  society  at  large  actually  obtains  is  evident  enough.  That 
is,  society's  use  of  its  income  or  income-bearing  resources  is  in  fact 
guided  by  the  market  demand  schedules  which  were  studied  in 
earlier  chapters.  Through  the  guidance  of  these  schedules,  re- 
sources are  so  employed  that  the  marginal  want  satisfied  in  any  one 
of  many  different  lines  is  equal, — when  measured  by  the  persons 
interested,  in  a  unit  which  is  at  least  nominally  the  same, — to  the 
marginal  want  satisfied  in  any  other  of  those  different  lines.  In 
other  words,  if  we  recognize  demand  prices  as  a  true  index  of  the 


XLVI]  CRITIQUE  OF  PRODUCTION  REGULATION  55! 

size  of  wants,  then  I  dollar's  worth  of  resources  are  used  to  satisfy 
what  seem  to  be  $i  wants,  not  5o-cent  wants  nor  $2  wants.  But, 
while  such  a  rule  does  obtain  for  society  in  general,  the  question 
remains  whether  this  rule  can  be  interpreted  and  justified  as  the 
analogous  rule  is  in  the  case  of  the  individual.  Are  these  demand 
prices  of  the  general  demand  schedules  a  true  index  of  the  real 
social  magnitude  of  wants  ?  Do  they  express  comparative  social  or 
general  importances  in  anything  like  the  same  way  that  the  demand 
prices  of  the  individual  schedule  express  comparative  individual  im- 
portances? If  they  do, — and  only  if  they  do — we  may  say  that  the 
guidance  of  production  effected  through  them  in  a  rough  way 
secures  the  gratification  of  wants  in  proportion  to  their  importance, 
and  is,  therefore,  a  reasonable  one. 

Affirmative  Answer. — This  question  has  already  been  an- 
swered in  the  affirmative  on  pages  507-510.  Given  a  system  of  dis- 
tribution approved  by  society  (and  a  system  of  distribution  cannot 
exist  without  this  approval),  the  general  demand  schedules  are  social 
schedules,  schedules  representing  social  significances  or  importances, 
as  these  are  determined  by  the  vast  complex  of  conditions  which  at 
any  moment  prevails.  To  this  broad  statement,  there  are  several 
qualifications,  as  already  brought  out ;  but  the  statement  is,  after 
all,  substantially  true.  The  objection,  that,  on  account  of  the  differ- 
ent meanings  of  the  money  measure  to  different  persons,  the  prices 
of  the  general  demand  schedule  do  not  represent  the  absolute  mag- 
nitude of  wants,  has  already  been  sufficiently  answered.  The  rea- 
sonable, the  proper,  guide  to  the  use  of  the  resources  belonging  to  a 
social  group  is  not  the  absolute  magnitude  of  wants  but  their  social 
magnitude.  Production  should  be  so  guided  as  to  secure  the  greatest 
social,  not  individual,  advantage.  We  are  not,  therefore,  concerned 
with  absolute  magnitudes. 

If  the  objection  is  to  be  interpreted  as  really  directed  against  the 
use  of  the  term  "utility"  and  the  phrase  "marginal  utility''  in  this 
connection,  the  matter,  like  other  verbal  controversies,  is  not  of 
great  moment.  The  general  point,  however,  is  important.  In  ac- 
cepting the  guidance  of  ordinary  demand  schedules  in  the  use  of  its 
resources,  society,  broadly  speaking,  insures  that  those  resources 


552  PRINCIPLES  OF  ECONOMICS  [XLVI 

shall  be  used  in  a  way  which  provides  for  the  satisfying  of  wants  in 
proportion  to  their  social  significance. 

IV 
Are  Prices  Which  Follow  Cost  Proper  Guides  of  Production? 

Among  the  most  important  of  the  principles  through  which  prices 
are  determined  are  those  which  affirm  some  kind  or  degree  of  causal 
connection  between  price  and  cost  of  production.  Broadly  speaking, 
in  most  cases  prices  have  to  equal  marginal  cost  of  production ;  or, 
anyhow,  the  prices  of  different  goods  have  to  show  the  same  ratios 
as  their  costs  of  production.  A  commodity  costing  twice  as  much 
as  some  other  commodity  must  have  a  price  approximately  twice  as 
high.  Is  such  a  principle  as  this  a  suitable  element  in  the  mechanism 
which  regulates  production?  Does  it  tend  to  insure  that  our  re- 
sources shall  be  most  wisely  utilized  ? 

Here,  again,  the  answer  is  certainly  an  affirmative  one.  Prices 
which  have  the  regulating  of  production,  which  are  called  on  to 
utilize  our  resources  to  the  best  advantage,  can  do  this  only  on  con- 
dition that  they  are,  generally  speaking,  coincident  with  marginal 
cost.  Correct  prices,  prices  fitted  to  guide  production  rightly,  must 
be  adjusted,  not  only  to  demand  prices  and  the  forces  behind  them, 
but  also  to  supply  prices.  If  the  price  of  any  particular  commodity, 
as  compared  with  those  of  other  commodities,  was  higher  than  its 
cost,  this  could  be  only  because  that  price  was  being  held  up  by  a 
marginal  significance  or  utility  abnormally  high  as  compared  with 
that  of  other  commodities  having  the  same  cost.  But,  since  it  is  our 
business  so  to  use  our  productive  resources  that  a  given  unit  of  those 
resources  yields  equal  or  almost  equal  marginal  utilities  all  along  the 
line,  the  abnormally  high  marginal  utility  of  our  special  commodity 
would  mean  that  too  little  of  our  resources  was  being  used  in  the 
production  of  that  commodity,  too  much  in  the  production  of  other 
commodities.  On  the  other  hand,  if  the  price  of  any  particular 
commodity,  as  compared  with  those  of  other  commodities,  was 
below  its  cost  of  production,  this  could  be  only  because  that  price 
was  being  held  down  by  a  marginal  significance  or  utility  which  was 
abnormally  low  as  compared  with  that  of  other  commodities  having 


XLVI]  CRITIQUE  OF  PRODUCTION  REGULATION  553 

the  same  cost.  But,  in  view  of  our  rule  of  equal  marginal  utilities, 
this  abnormally  low  marginal  utility  of  our  special  commodity  would 
mean  that  too  much  of  our  resources  was  being  used  in  its  produc- 
tion, too  little  in  the  production  of  other  commodities. 

ILLUSTRATIVE  PROBLEM 

"Our  attitude  on  the  matter  of  pay  to  teachers  is  simply  absurd.  We 
pay  less  for  this  function  which  has  such  supreme  importance  to  society 
than  to  the  least  skilled  mechanic  working  in  an  automobile  factory.  But 
we  shall  be  brought  to  our  senses  one  of  these  days  by  learning  that  we 
simply  will  not  be  able  to  get  teachers  at  the  beggarly  wages  we  pay." 

Of  these  two  reasons  for  paying  higher  wages  to  teachers,  the  former 
is  from  the  standpoint  of  economic  science  a  worthless  one;  the  latter  a 
good  one.  Defend  that  statement. 


CHAPTER  XLVII 

CRITIQUE  OF  PRODUCTION  IN  RESPECT  TO 
EFFICIENCY 

In  beginning  the  last  chapter  we  said  that  a  satisfactory  economic 
order  might  reasonably  be  expected  to  produce  the  right  things,  to 
produce  them  in  large  quantity,  to  produce  them  of  excellent  quality, 
and  to  produce  them  without  marked  irregularities.  We  have  thus 
far  seen  that  the  existing  order,  governed  as  it  is  by  the  laws  of 
price,  meets  the  first  of  these  conditions — the  production  of  the 
right  things — reasonably  well.  It  is  the  task  of  the  present  chapter 
to  make  a  similar,  though  briefer,  test  of  the  three  remaining 
conditions. 

I 

The  Present  Order  and  a  Large  Volume  of  Products 

To  the  question  whether  the  present  order  is  fitted  to  make  the 
volume  of  products  large,  almost  all  students  of  our  subject  give  a 
favorable  answer.  In  general,  abundance  of  products  must  depend 
chiefly  on  three  conditions  :  ( i)  a  large  volume  of  productive  factors, 
(2)  high  efficiency  in  those  factors,  and-  (3)  most  profitable  utilizing 
of  those  factors.  Let  us  consider  these  in  order. 

Volume  of  Capital. — As  respects  the  volume  of  resources,  no 
system  can  alter  this  as  far  as  it  depends  upon  nature.  But  the  fac- 
tors dependent  on  human  choice — all  forms  of  labor,  waiting,  and 
initiative  or  responsibility-taking — may  be  supplied  in  small  or  in 
large  volume  according  to  conditions.  As  regards  the  second  and 
third,  the  present  order  promises  to  do  much  better  than  any  substi- 
tute ever  seriously  considered.  A  large  volume  of  capital,  which 
is  the  sole  condition  for  an  abundant  supply  of  waiting  power  and 
the  principal  one  for  an  abundant  supply  of  initiative,  is  surely 

554 


XLVII]          CRITIQUE  OF  PRODUCTION  EFFICIENCY  555 

more  likely  to  be  realized  under  the  present  order  than  under  social- 
ism. With  the  present  order,  the  accumulation  of  capital  is  left  to 
private  initiative,  and  a  reward  offered,  in  the  shape  of  interest  and 
profits,  makes  possible  the  attaining  of  a  competency  with  its  free- 
dom from  labor.  Under  socialism,  private  capital,  anyhow  private 
interest  and  profits,  would  be  eliminated.  Society  would,  therefore, 
have  to  depend  on  something  akin  to  taxation  as  a  means  for  accu- 
mulating capital.  But  in  a  democratic  state,  with  inequalities  of 
income  eliminated  or  much  reduced,  it  is  hard  to  believe  that  capital 
could  be  largely  accumulated  by  such  a  method. 

Volume  of  Labor  Services. — Turning  to  the  labor  factor,  we 
must  admit  that  a  socialistic  order  would  show  less  difference ;  but  it 
would  after  all  give  smaller  resources  than  the  present  order.  One 
of  the  leading  aims  of  socialism  is  to  diminish  individual  responsi- 
bility in  economic  things.  It  does  not,  indeed,  plan  to  go  as  far  as 
communism,  treating  all  members  of  the  community  as  if  they  were 
members  of  one  common  family, — insuring  them  a  livelihood  any- 
how. But  it  does  propose  to  go  a  long  way  in  this  direction, — to 
insure  everyone  a  job  and  a  so-called  living  wage, — to  relieve  every- 
one of  much  of  the  anxiety  which  characterizes  the  present  order. 
Now,  this  may  be  on  the  whole  very  desirable ;  but  it  can  scarcely 
fail  to  reduce  the  energy,  industry,  alertness,  and  prudence  which 
men  bring  to  their  tasks  under  the  present  order,  where  the  liveli- 
hood and  the  economic  position  of  each  individual  are  conditioned  on 
the  contribution  he  makes  to  the  supposed  welfare  of  his  fellows. 

Efficiency. — What  has  been  said  concerning  the  volume  of 
the  factors  available  applies  in  considerable  measure  to  their  effi- 
ciency. That  feature  of  the  present  order  which  makes  the  share  of 
each  person  dependent  on  his  contribution  as  measured  by  others, 
stimulates  him — assuming  free  competition — to  raise  the  efficiency 
of  the  factor  in  his  control  as  high  as  possible,  in  other  words,  to 
furnish  efficient  services.  Finally,  the  system  of  private  initiative 
probably  promises  to  give  greater  efficiency  in  the  utilisation  of  the 
factors ;  though  it  is  doubtless  true  that  governmental  action  can 
contribute  much  at  this  point,  particularly  by  the  discovery  of  better 


556  PRINCIPLES  OF  ECONOMICS  [XLVII 

methods  in  industries  where  private  initiative  seems  backward.  In 
general,  then,  we  may  conclude  that  under  the  present  order  all  the 
necessary  conditions  are  fulfilled  for  securing 'a  large  volume  of 
products. 

Objections. — The  above  verdict  is  concurred  in  by  almost 
all  economists.  Yet  perhaps  a  moment  should  be  given  to  the  oppos- 
ing contention  of  certain  critics  that  the  present  order  is  not  pro- 
ductively successful.  In  support  of  this  idea  they  bring  forward 
three  considerations  chiefly:  the  wastes  of  competition,  the  idleness 
of  the  parasitic  classes,  and  the  sacrifice  of  utility  to  value. 

The  first  of  these  points  is  easily  answered.  There  are  undoubt- 
edly wastes  in  a  system  of  free  private  initiative, — though  their 
amount  is  grossly  exaggerated, — but,  in  the  opinion  of  the  econ- 
omist, this  so-called  waste  is  merely  the  cost  of  a  rarely  efficient 
initiative,  and  a  low  cost  at  that.  For  all  students  of  business  or- 
ganization agree  that  the  monopolistic  and  quasi-monopolistic  busi- 
ness units  are  much  less  efficiently  organized  today  than  are  the 
units  exposed  to  free  competition. 

Again,  we  cannot  take  more  seriously  the  talk  about  the  wasted 
productive  capacities  of  the  parasitic  classes.  To  start  with,  their 
number  is  extremely  small.  A  large  proportion  of  the  persons  often 
designated  as  parasites  are  in  fact  performing  functions  essential 
to  high  productive  efficiency.  In  the  second  place,  it  seems  certain 
that,  if  they  all  were  to  become  producers  in  the  socialist  sense,  the 
amount  they  would  add  to  the  income  of  each  person  would  be 
scarcely  appreciable. 

Finally,  the  third  objection  of  the  socialist  seems  to  economists 
to  be  a  serious  error.  There  is  no  doubt  the  possibility  of  a  contra- 
diction between  utility  and  value.  One  who  is  seeking  only  to 
increase  values  may  find  himself  in  a  position  where  he  would  better 
diminish  output  and  so  diminish  utilities ;  and,  since  the  immediate 
return  to  producers  is  a  value  return  (purchasing  power  in  the  form 
of  money)  rather  than  a  utility  one,  it  naturally  follows  that  pro- 
ducers may  at  times  gain  most  by  reducing,  or  at  least  checking, 
the  increase  of  utilities.  But  the  pursuit  of  such  a  policy  is  possible 
onlv  through  concert  of  action  among  producers;  since  values  can 


XLVII]  CRITIQUE  OF  PRODUCTION  EFFICIENCY  557 

be  increased  by  limiting  output,  only  provided  it  is  the  total  output 
which  is  thus  limited,  not  merely  that  of  some  producers.  But 
concert  of  action  among  producers  is  in  contradiction  to  the  very 
essence  of  the  present  order  of  which  untrammeled  private  initiative 
is  the  dominant  feature.  Accordingly,  it  is  quite  illegitimate  to 
represent  this  order  as  one  in  which  producers  will  inevitably  seek 
to  increase  values  to  the  neglect,  or  even  the  destruction,  of  utilities. 
Increase  of  values  is  doubtless  the  natural  goal  of  the  producer  as 
producer ;  but,  under  a  regime  of  free  competition,  the  only  path  by 
which  that  goal,  generally  speaking,  can  be  attained  is  the  increase 
of  utilities* 

II 
The  Present  Order  and  Qualitative  Excellence  in  Products 

The  third  requisite  of  an  effective  regulative  mechanism  for  an 
economic  order  is  fitness  to  insure  that  products  should  be  of  high 
quality  as  well  as  abundant  in  quantity.  Is  this  requisite  likely  to 
be  present  in  a  regulative  mechanism  which  consists  of  freely  de- 
termined prices?  At  this  point,  it  seems  to  me,  our  verdict  cannot 
be  so  favorable.  Doubtless  the  discriminating  demands  of  buyers 
will  secure  high  quality  in  some  few  products,  through  the  natural 
competition  of  producers.  But  with  the  majority  of  products  this 
rule  will  not  apply.  Unless  government  steps  in  to  supplement  the 
control  effected  by  freely-determined  prices,  we  almost  everywhere 
meet  with  adulteration,  poor  materials,  bad  workmanship,  etc.  This 
might  be  remedied  if  buyers  became  more  alert,  better-informed,  and 
more  insistent  with  regard  to  their  rights.  But  the  likelihood  of  any 
such  change  is  very  remote.  At  many  points  buyers  would  find 
great  difficulty  fitting  themselves  to  guard  their  interests  even  were 
they  disposed  to  take  the  trouble ;  at  some  others  they  are  pretty 


1  The  last  objection  is  perhaps  given  too  little  weight  in  view  of  the 
present  trade-union  policy  of  encouraging  or  requiring  the  limitation  of 
output, — a  policy  which  would  probably  be  less  pronounced  under  socialism 
than  it  is  today.  Doubtless  the  diminution  or  disappearance  of  the  open 
approval  of  soldiering  would  tend  to  result  in  a  considerable  increase  in  out- 
put. On  the  whole,  however,  I  believe  that  this  would  be  more  than  offset 
in  a  socialist  order  by  the  diminution  in  motive  for  effort  due  to  the  much 
less  rigid  connection  between  wage  received  and  service  rendered. 


558  PRINCIPLES  OF  ECONOMICS  [XLVII 

likely  to  be  misled  despite  their  efforts.  Much  evil  may  thus  result 
both  to  individuals  and  the  community ;  so  we  cannot  afford  to  leave 
regulation  to  the  working  of  spontaneous  forces.  It  should  be 
added,  however,  that  the  partial  failure  of  price  control  in  this 
respect  does  not  constitute  a  very  serious  defect  in  the  present  order, 
because  the  needed  supplemental  action  of  government  is  compara- 
tively easy  to  work  out,  as  has  been  shown  by  the  experience  of  the 
last  sixty  years  in  England. 

Ill 
The  Present  Order  and  Continuity  of  Production 

An  economic  order  in  which  the  regulative  mechanism  was  effi- 
ciently operative  for  short  periods  only, — being  every  now  and  then 
completely  thrown  out  of  gear  so  that  a  highly  disordered  state  of 
things  ensued, — would  be  considered  by  everyone  seriously  de- 
fective, if  not  almost  unendurable.  An  economic  order  to  be  really 
satisfactory,  ought  to  show  steadiness,  regularity,  dependableqess, — 
ought  to  be  free  from  all  marked  perturbations.  Now  in  this  respect, 
our  system  unfortunately  does  not  work  so  well  or  we  might  desire. 
It  is  a  familiar  fact  that  production  is  subject  to  marked,  almost 
violent,  fluctuations,  which  naturally  group  themselves  into  the  so- 
called  industrial  cycle;  depression,  recovery,  increasing  activity, 
normal  activity,  over-trading,  crisis,  collapse,  depression,  and  so 
around  again.  The  claim  of  the  socialist  that  public  initiative  would 
almost,  if  not  quite,  eliminate  this  sort  of  thing  is  without  doubt  a 
fairly  reasonable  one.  At  all  events,  socialism  would  be  certain  to 
work  better  at  this  point  than  does  the  present  system.  The  fact, 
however,  is  that  the  industrial  cycle,  in  its  serious  forms,  is  a  com- 
paratively modern  disease,  little  more  than  a  century  old ;  and  much 
has  already  been  done  by  our  system  to  bring  it  under  control. 
America,  for  reasons  easy  to  trace,  is  still  much  subject  to  attack. 
But  England,  the  original  home  of  great  panics,  has  had  no  serious 
crisis  since  1866.  In  short,  the  leaders  of  industry  are  learning  to 
control  things  sufficiently  to  safeguard  this  trouble  or  to  palliate 
greatly  its  evils.  Accordingly,  while  the  present  order  cannot  be 
cleared  of  blame,  we  should  surely  be  unjustified  at  the  present  time 


XLVII]        CRITIQUE  OF  PRODUCTION  EFFICIENCY 

in  pronouncing  a  final  verdict  against  it  on  account  of  the  defect 
in  question. 

IV 
Conclusion 

We  set  out  upon  this  discussion  by  asking  whether  the  system 
of  regulating  production  through  freely  determined  prices  works  out 
reasonably  satisfactory  results.  What  answer  may  we  draw  from 
the  facts  presented  above?  We  may,  and  apparently  are  compelled 
to  draw  an  affirmative  answer — an  affirmative  qualified,  but  still  an 
affirmative.  The  results  are  certainly  below  the  best  conceivable. 
Nevertheless,  while  great  improvements  are  needed,  are  possible, 
and  ought  to  be  effected,  we  must  still  hold  that  a  verdict  for  the 
substantial  soundness  of  the  system  is  practically  inevitable.  We 
may  add  that  a  thoroughly  humane  despot  with  power  to  substitute 
any  other  system  thus  far  proposed,  might  very  probably — if  he  took 
all  the  facts  into  consideration — decide  that  the  system  now  opera- 
tive was  on  the  whole  the  very  best  one  possible. 


CRITIQUE  OF  CONSUMPTION 

In  concluding  our  study,  let  us  consider  for  a  moment  the  satis- 
factoriness  of  the  present  order  with  respect  to  consumption.  Con- 
sumption, sometimes  treated  as  one  of  the  main  divisions  of  econom- 
ics, coordinate  with  production,  exchange  and  distribution,  has 
for  various  reasons  been  given  little  prominence  in  this  volume. 
Nevertheless,  our  critique  of  the  present  order  ought  not  to  end 
without  a  brief  comment  on  the  way  in  which  the  price  regulative 
feature  affects  consumption — the  use  which  is  made  of  wealth — 
and  without  some  attempt  to  determine  whether  the  result  is  satis- 
factory or  the  reverse. 

As  respects  the  regulation  of  consumption,  a  satisfactory  system 
needs  to  show  three  results  chiefly:  (i)  Those  natural  resources 
which  belong  to  society  as  a  whole  and  to  posterity  must  not  be 
sacrificed  to  the  selfish  greed  of  the  individual  and  the  present;  (2) 
the  satisfaction  of  immediate  wants  must  not  absorb  all  our  pro- 
ducing efforts  to  the  neglect  of  that  building  of  capital  on  which 
great  productive  efficiency  depends;  and  (3)  the  best  utilization  of 
a  stock  of  consumption  products  already  existing  should  be  assured. 

The  first  of  these  demands,  we  must  admit  at  once,  is  very  im- 
perfectly provided  for  in  the  present  order.  Under  the  free  working 
of  private  initiative,  the  vast  resources  of  a  continent  in  lumber, 
coal,  iron,  etc.,  are  being  rapidly  dissipated,  and  that  in  too  large 
measure  for  the  benefit  of  very  small  classes.  Even  the  race  itself 
has  been  threatened  with  serious  deterioration  through  an  unbridled 
use  of  liberty  in  the  employment  of  women  and  children;  so  that 
everywhere  governmental  interference  has  proved  a  necessity.  All 
this  is  natural  enough.  When  we  are  dealing  with  the  interests  of 
the  remoter  future,  it  is  only  within  quite  narrow  limits  that  we  can 
trust  the  forces  which  ordinarily  prove  efficient  and  safe  regulators 

560 


XLVIII]  CRITIQUE  OF  CONSUMPTION  561 

of  economic  action.  The  safeguarding  of  those  interests  is.  a  duty 
which  from  its  very  nature  rests  upon  the  group,  rather  than  the 
individual.  Unfortunately,  the  group  too  rarely  rises  above  the 
standpoint  of  those  individuals  who  are  economically  most  powerful 
and  greedy ;  so  that  the  duty  of  the  group  in  this  respect  is  too  fre- 
quently neglected.  Still  it  cannot  be  doubted  that  our  only  hope  lies 
in  this  direction.  Government  must  put  great  and  rigid  limitations 
on  private  initiative  if  the  social  patrimony  is  to  be  saved  at  all. 

As  regards  the  second  requisite  of  a  system  which  properly  regu- 
lates consumption — that  it  should  not  permit  the  satisfaction  of 
immediate  wants  to  absorb  all  our  productive  efforts  to  the  neglect 
of  capital-building — our  present  system  can  give  an  excellent  account 
of  itself, — a  better  account,  probably,  than  could  be  given  by  any 
system  depending  on  public  initiative.  Capital  increases  at  an  amaz- 
ing pace.  The  increase  is  doubtless  not  a  little  due  to  a  feature  of 
the  system  which  is,  in  many  respects,  undesirable,  the  extreme 
inequality  of  incomes ;  for  this  concentrating  so  much  in  the  hands 
of  a  few  makes  the  task  of  saving  relatively  easy.  But  there  is 
another  explanation.  The  present  system  powerfully  stimulates 
accumulation  in  that  it  offers  to  those  who  save,  great  rewards,  not 
so  much  in  the  shape  of  interest,  as  in  the  shape  of  those  profits 
which  may  be  obtained  by  the  skillful  use  of  a  small  initial  sum.  A 
further  reason  is  found  in  the  fact  that  the  present  system  supplies 
highly  convenient  and  efficient  machinery  for  assisting  the  process 
of  capital-building,  in  the  shape  of  savings  banks,  insurance  com- 
panies, bond  exchanges,  and  the  like. 

The  third  requisite — the  best  utilization  of  an  already  existing 
stock  of  consumption  products — is  easily  met  by  the  present  system, 
save  under  quite  exceptional  circumstances.  It  belongs  to  the  very 
nature  of  the  laws  of  exchange  to  establish  a  price  which  adjusts 
demand  to  stock :  reducing  demand,  if  stock  is  deficient,  by  raising 
price;  increasing  demand,  if  stock  is  excessive,  by  lowering  price. 
But  here,  again,  we  are  confronted  with  the  "rich-man-poor-man" 
objection  which  was  brought  forward  against  the  present  regulation 
of  production.  "Demand,"  it  is  said,  "is  doubtless  adjusted  to  stock 
by  being  cut  down  through  higher  price;  but  unfortunately  this 
means  that  the  demand  of  the  poor  is  reduced  while  that  of  the  rich 


562  PRINCIPLES  OF  ECONOMICS  [XLVIII 

remains  at  its  old  level."  Now,  there  is  doubtless  some  truth  in 
this;  the  burden  of  curtailing  consumption  will  often  fall  more  on 
the  poor  than  on  the  rich.  Further,  just  as  in  production,  circum- 
stances may  arise  where  the  discrepancy  between  the  real  magnitude 
of  wants  and  their  effective  magnitude  as  expressed  in  price  is  so 
great  that  it  becomes  the  duty  of  society  to  interfere  with  the  auto- 
matic regulation  and  determine  by  authority  the  destination  of  its 
resources.  Thus,  when  a  famine  of  food,  fuel,  or  other  fundamental 
necessary  threatens,  it  usually  becomes  the  duty  of  government  to 
intervene,  even  perhaps  to  the  extent  of  taking  upon  itself  the  task 
of  distributing  these  commodities. 

But,  while  extraordinary  circumstances  may  arise  which  call  for 
some  other  method  of  regulating  consumption,  the  regulation  by 
freely-determined  price  is  on  the  whole  fairly  well  adapted  to  most 
needs  of  human  society.  In  the  first  place,  it  is  easy  to  exaggerate 
the  seriousness  of  the  objection  that  in  times  of  stock-deficiency, 
regulation  through  price  throws  the  entire  burden  of  curtailing  con- 
sumption on  the  poor.  Save  with  respect  to  a  very  few  commodi- 
ties, indeed,  the  number  of  families  who  do  not  reduce  consumption 
at  all  when  price  rises  is  very  small, — so  small  that  its  continuance 
of  the  old  scale  cannot  materially  alter  the  result;  and  here  the 
government  should,  and  usually  does,  step  in  and  adjust  the  matter. 
In  the  second  place  the  maintenance  of  a  consumption  policy  which 
treats  wants  as  having  a  social  importance  corresponding,  not  to 
their  absolute  magnitude,  but  rather  to  their  apparent  magnitude  as 
expressed  in  the  demand  schedules  of  individuals,  is  a  necessary 
complement  to  the  system  of  distribution  which  is  permitted  to 
obtain.  If  incomes  can  legitimately  be  unequal, — and  we  have 
argued  that  they  really  must  be  unequal, — the  needs  of  persons 
having  unequal  incomes,  needs  which  are,  absolutely  considered, 
equal,  must,  after  all,  be  treated  as  having  unequal  social  impor- 
tances. For  any  other  policy  would  destroy  the  inequality  of  in- 
comes which  by  hypothesis  is  necessary. 


APPENDIX  . 
EXPLANATORY  NOTES 

Note  i 

A  somewhat  different  solution  of  the  difficulty  which  in  the  text 
was  met  by  the  use  of  the  concept  "capital  as  capital"  makes  the 
essence  of  capital  to  reside  in  the  fund  of  value  embodied  in  the 
goods  commonly  called  capital.  This  is  real  capital,  pure  capital, 
value  capital.  In  contrast,  the  goods  are  concrete  capital  or  goods 
capital  or  capital  goods. 

Closely  allied  to  the  last  distinction  is  one  which  contrasts  money 
capital  with  real  or  goods  capital.  The  former  is  the  fund  of 
money  which  is  accumulated  and  then  used  to  purchase  the  goods 
capital ;  or,  better,  perhaps,  which  is  conceived  as  having  been  put 
into  the  goods  capital.  This  in  turn  suggests  the  distinction  of 
invested  capital  and  free  capital,  a  distinction  which  the  terms  suffi- 
ciently explain. 

A  distinction  which  is  sometimes  useful  is  that  between  formal 
or  money  capital  and  real  or  goods  capital.  The  former  is  the  fund 
of  money  or  bank  credit  which  the  capitalist  accumulates;  while  the 
latter  consists  of  the  actual  goods,  the  engines,  machines,  coal,  etc., 
which  are  elsewhere  produced  to  be  bought  with  the  money  capital. 
This  distinction  emphasizes  the  point  that  the  things  which  we  are 
really  trying  to  get  are  the  engines,  machines,  etc.,  the  fimd  of  money 
being  only  a  go-between.  The  distinction  must  not  however,  be 
taken  too  seriously.  In  a  very  important  sense,  the  nan  who  ac- 
cumulates the  mere  fund  of  money  is  responsible  for  tnc  existence 
of  the  engines,  etc.  He  it  is  who  supplies  the  waiting  power  which 
makes  possible  this  particular  employment  of  our  productive  re- 
sources. 

Among  older  ways  of  distinguishing  different  forms  of  capital 
is  one  which  contrasts  fixed  and  circulating  capital.  The  former  is 

563 


564  PRINCIPLES  OF  ECONOMICS 

capital,  like  a  tool  or  a  machine,  which  gives  off  more  than  one 
service,  while  the  latter  is  capital,  such  as  the  raw  material  used  in 
making  a  wooden  box  or  the  coal  burned  in  a  steam  engine,  which 
does  its  part  in  a  single  use,  gives  off  but  one  service.  An  interesting 
contrast  is  often  drawn  between  specialised  and  general  capital. 
Specialized  capital  is  the  kind  which  is  fitted  for  one  purpose  only 
or  for  a  very  few  purposes  at  most,  for  example,  a  planer,  a  copper 
steamer,  or  a  printing  press.  Generalized  capital  on  the  other  hand 
is  something  like  .coal,  or  pig  iron,  or  most  of  all,  money,  which 
can  be  put  to  any  one  of  many  uses. 

Most  people  broaden  the  concept  of  capital  as  "products  devoted 
to  further  production,"  making  capital  synonymous  with  income- 
getting  goods,  or  all  goods  which  serve  their  owner  indirectly  by 
supplying  him  with  other  goods.  If  we  take  the  word  in  this  sense, 
it  is  necessary  to  recognize  a  distinction  between  social  capital  and 
private  or  acquisitive  capital.  Social  capital,  which  is  virtually  the 
same  as  that  discussed  in  the  foregoing  paragraphs,  produces  other 
products,  and  is  therefore  income-giving  even  from  the  social  point 
of  view.  But  private,  or  acquisitive  capital — for  example,  a  gasoline 
launch  rented  to  a  summer  resorter — does  not  increase  the  total 
volume  of  goods  and  so  is  not  income-bearing  from  the  social  stand- 
point ;  it  yields  an  income  to  its  owner  only. 

Some  writers  include  under  the  term  capital  all  durable  products, 
not  only  those  devoted  to  production,  but  those,  such  as  a  dwelling 
house  occupied  by  its  owner,  which  are  devoted  to  consumption 
as  well.  While  the  older  usage  is  preferred  by  most  authorities, 
there  is  much  to  be  said  in  favor  of  the  new.  Indeed,  the  emphasis 
we  have  laid  on  "carrying"  as  the  distinctive  mark  of  capital  as 
capital  makes  such  an  extension  of  the  field  to  which  the  term 
is  applied  almost  necessary.  Durable  goods  are,  as  such,  goods  which 
give  off  their  uses  on  the  installment  plan,1  that  is,  only  a  part  of 
the  services  which  they  are  capable  of  yielding  can  be  enjoyed  this 
year,  1921 ;  we  must  wait  for  some  of  them  till  next  year,  for 
others  till  1923,  and  so  on.  We  can  afford  to  resort  to  the  use  of 
such  durable  or  instalment-service  goods,  e.g.,  brick  houses  instead 


1 1  sometimes  call  such  goods  "installment-service"  goods. 


EXPLANATORY  NOTES  565 

of  wooden  ones,  only  on  condition  that  we  have  the  necessary  power 
to  wait,  to  put  into  the  house  a  great  amount  of  productive  resources 
which  will  in  large  measure  yield  its  returns  only  after  the  lapse  of 
a  long  period. 

A  very  natural  extension  of  the  term  capital  makes  it  to  include 
such  facilities  and  constructions  as  highways,  canals,  and  bridges, 
which  are  usually  maintained  by  the  government.  These  things 
manifestly  show  the  characteristics  of  being  produced  and  devoted 
to  further  production.  They  are  not,  however,  subject  to  private 
ownership,  and  so  do  not  have  a  price ;  hence  they  are  not  wealth  in 
the  usual  sense,  and,  if  capital  is  to  be  restricted  to  wealth  in  that 
sense  these  things  are  not  capital.  A  natural  compromise  is  to  call 
them  public  capital. 

A  less  legitimate  broadening  of  our  term  takes  in  the  body  of 
knowledge  handed  down  from  generation  to  generation  which  plays 
a  very  large  part  in  economic  production.  In  a  sense,  this  has  been 
and  is  being  produced ;  and  it  is  obviously  being  used  to  assist  pro- 
duction. It  is  not,  however,  included  among  the  things  which  possess 
exchange  value,  command  a  price.  It  is  not,  therefore,  wealth ;  and, 
not  being  wealth,  it  can  be  called  capital  only  in  a  figurative  way.  It 
is  sometimes  designated  social  or  public  capital. 

Finally,  it  is  sometimes  convenient  to  speak  of  personal  capital, 
in  reference  to  the  bodily  or  mental  capacities  and  aptitudes  of 
human  beings.  Most  economists,  however,  consider  such  language 
figurative.  Capital  is  only  a  particular  kind  of  wealth,  or  wealth 
looked  at  in  a  particular  way.  But  personal  capacities  are  not  wealth 
because,  not  being  transferable,  they  have  no  exchange  value;  and  if 
they  are  not  wealth,  they  cannot  be  called  capital  in  the  economic 
sense  of  the  term. 

Note  2 

In  connection  with  the  concept  of  "marginal  product"  discussed 
on  page  131,  a  possible  misunderstanding  should  be  guarded  against. 
The  propriety  of  this  designation  for  the  addition  to  output  conse- 
quent upon  the  addition  of  a  unit  of  the  changing  factor  is  ques- 
tionable, but  conforms  to  the  common  usage  of  current  economic 


566  PRINCIPLES  OF  ECONOMICS 

writing.  In  saying  that,  in  combination  n,  the  marginal  product 
of  the  L's  is  15,  that  is,  that  the  2  L's  added  in  that  combination 
"produce"  the  30  units  of  additional  output,  we  do  not  mean  that 
these  2  L's  are  alone  responsible  for  bringing  into  existence  those 
30  units  of  product.  Such  a  contention  would  be  absurd.  When 
each  of  several  factors  must  necessarily  be  present,  if  a  given  result 
is  to  be  brought  about,  no  one  of  them  taken  by  itself  can  be 
physically  or  technically  credited  with  the  production  of  that  result, 
or  any  assigned  part  of  it.  The  whole  266  units  of  product  resulting 
from  combination  n  are  produced  by  the  union  of  all  the  N's  and 
all  the  L's  entering  into  the  combination.  The  2  new  L's  could 
produce  nothing  if  the  20  N's  were  not  present.  That  is,  the  N's 
are  just  as  necessary  to  the  production  of  the  additional  30  units 
of  product  as  the  additional  L's;  for  there  is  no  degree  in  necessity. 
In  short,  it  cannot  be  too  much  emphasized  that  there  is  no  possi- 
bility of  isolating  any  portion  of  the  product  and  saying  that  it  was 
produced  by  any  particular  unit  or  units  of  any  of  the  factors  in  any 
physical  sense. 

What,  then,  do  we  mean  by  crediting  a  particular  portion  of  the 
product  to  a  particular  pair  of  L's  ?  Simply  this :  that,  in  view  of 
all  the  circumstances,  it  is  reasonable  to  act  as  if  those  L's  were 
alone  responsible  for  the  added  units  of  product.  These  circum- 
stances may  arise  in  several  different  ways.  One  of  the  best  cases, 
perhaps,  is  met  when  a  particular  unit  of  some  factor,  say  a  piece  of 
land,  is  superior  to  other  units  in  actual  use,  which,  however,  are  so 
numerous  that  they  can  be  ignored  in  economic  reckoning, — are  in 
effect  free  goods.  Since  these  units  of  the  superabundant  grade  can 
be  treated  as  non-economic  factors,  no  part  of  their  product,  say 
20  bushels  per  acre,  will  be  credited  to  them.  The  farmer  as  a 
laborer,  or  as  a  laborer  and  capitalist,  will  receive  the  whole  product. 
But,  if  a  man  can  afford  to  expend  his  efforts  getting  only  the  20 
bushels  yielded  by  the  non-economic  land,  he  can  afford  to  pay  some- 
thing for  the  control  of  a  piece  of  land  which  would  yield,  with 
the  same  effort,  24  bushels.  He  can  without  impropriety  affirm  that 
such  control  would  add  4  bushels  to  his  output.  He  may,  without 
being  led  into  any  practical  error,  conceive  these  4  bushels  to  be  the 
product  of  the  land  alone,  though  they  are  really  no  more  the  product 


EXPLANATORY  NOTES  567 

of  the  land  than  the  other  20  bushels;  and  none  of  the  24  bushels 
are  the  product  of  the  land  any  more  than  they  are  the  product  of 
the  farmer.  In  a  word,  the  real  fact  is  this:  from  the  economic 
standpoint,  we  act  reasonably  when  we  conceive  that  the  land  alone 
is  responsible  for  the  extra  four  bushels  given  off  by  this  better 
grade  of  land. 

In  the  case  just  considered,  we  were  enabled  to  ignore  the  share 
of  the  farmer  in  producing  four  bushels  of  the  total  product  and 
to  treat  those  four  bushels  as  the  special  product  of  the  land,  because 
the  maximum  share  going  to  the  farmer  was  already  determined  as 
the  product  which  he  could  get  on  the  non-economic  land.  Substan- 
tially all  that  he  could  get  beyond  that  he  must  regard  as  due  to  the 
special  piece  of  land  and,  so  doing,  he  can  reasonably  offer  to  pay 
to  the  owner  for  the  privilege  of  using  that  piece  of  land  anything 
less  than  four  bushels  of  product.  Another  case  wherein  it  is  legiti- 
mate to  ignore  one  of  the  factors  and  treat  a  particular  part  of  the 
product  as  due  exclusively  to  the  other  factor,  arises  when  for  any 
reason  such  other  factor  is  conceived  by  the  producer  as  fixed  in 
amount.  Thus  we  might  suppose  a  farmer  who  was  possessed  of 
a  piece  of  land  which  he  could  not  or  would  not  alienate,  even  in 
part,  and  to  which  he  could  not  or  would  not  make  any  addition, 
to  be  considering  how  much  he  could  afford  to  pay  a  farm  hand 
who  was  applying  for  a  job.  If,  under  such  conditions,  the  laborer 
could  add  200  bushels  of  wheat  to  the  farmer's  crop,  the  farmer 
could  afford  to  treat  his  services  as  worth  substantially  200  bushels 
of  wheat,  that  is,  he  might  reasonably  act  as  if  the  laborer  were 
alone  the  producer  of  these  200  bushels,  though  of  course  this 
would  not  be  true  in  any  literal  sense — those  200  bushels  would  be, 
like  all  the  other  bushels,  the  joint  product  of  the  several  factors 
involved. 

Note  3 

The  discussion  on  page  295  brought  out  the  point  that  4  differ- 
ent prices  of  the  demand  and  supply  schedule  play  decisive  roles 
in  the  immediate  fixation  of  price.  To  avoid  some  rather  persistent 
misunderstandings,  it  is  perhaps  desirable  to  note  some  differences 
in  the  processes  by  which  these  different  limiting  prices  operate. 


568  PRINCIPLES  OF  ECONOMICS 

The  marginal  demand  price  as  a  check  on  the  upward  movement  of 
actual  price,  and  the  marginal  supply  price  as  limiting  the  falling 
of  price  are  mere  indices  of  the  presence  of  the  real  causes  rather 
than  themselves  the  forces  accomplishing  the  results.  Thus,  when, 
in  the  silver  schedule  on  page  281,  the  actual  price  refuses  to  rise 
above  55  cents  lest  it  should  exclude  the  10,000  ounces  of  demand 
which  came  in  only  when  price  was  as  low  as  this,  the  fact  really 
bringing  about  this  result  is  the  absence  of  that  10,000  ounces  of 
demand  at  the  higher  figure,  56  cents,  not  the  presence  of  that  in- 
crement of  demand  at  55  cents.  This  is  seen  from  the  fact  that, 
had  there  been  no  new  demand  at  54,  or  53,  or  52,  or  any  lower 
price  whatever,  the  price  would  still  have  come  down  to  55  cents, — 
even,  in  fact,  to  54  cents. 

Analogous  statements  must  be  made  with  respect  to  the  marginal 
supply  price.  As  a  limit  to  the  falling  of  price  from  55  to  54  cents, 
it  is  little  more  than  an  index  of  the  presence  of  the  real  cause, 
that  is,  the  failure  of  supply  at  the  lower  price,  54  cents.  If  no 
wheat  whatever  could  be  supplied  at  55  cents,  the  price  could  not 
have  gone  down  to  54  cents  just  the  same, — in  fact  it  could  not 
have  gone  down  even  to  55. 

In  contrast  with  this  status  of  the  marginal  demand  and  marginal 
supply  prices  considered  as  upper  and  lower  limits,  respectively, 
the  first  extra-marginal  demand  and  supply  prices  are  themselves 
active  causes  in  fixing  the  position  of  actual  price.  That  price  cannot 
go  up  to  the  first  extra-marginal  supply  price  just  because  it  is  that 
price,  that  is,  because  it  of  itself  will  let  in  too  much  supply.  So  the 
actual  price  cannot  go  down  to  the  first  extra-marginal  demand  price 
just  because  it  is  that  price,  that  is,  because  it  will  of  itself  let  in  new 
increments  of  demand. 

Note  4 

As  remarked  on  page  316,  some  economists  hold  that  profits 
are  not  even  at  the  present  time  an  element  in  cost.  Two  of  the 
considerations  brought  forward  in  support  of  this  opinion  will  be 
briefly  commented  upon. 

First,  it  is  sometimes  remarked  that,  especially  in  the  industries 
which  involve  much  risk,  for  example,  gold  mining,  the  total  ex- 


EXPLANATORY  NOTES  569 

penditure — the  expenditure  over  the  whole  industry — is  probably 
much  greater  than  the  total  return:  some  surpluses  are  gained,  but 
more  deficits  are  incurred.  The  answer  to  this  is  easy.  That  any- 
thing should  be  a  cost  does  not  require  that  every  unit  of  that  thing 
should  be  remunerated.  The  only  question  is  this:  Is  the  forth- 
coming of  supply  dependent  to  an  appreciable  extent  on  the  covering 
of  a  particular  item  which  is  alleged  to  be  a  cost?  Are  there  en- 
trepreneurs who  will  continue  to  supply  commodities  only  on  con- 
dition that  they  get  from  the  business  a  return  on  their  capital  in 
excess  of  the  interest  which  they  could  get  simply  by  lending  that 
capital  ?  and  is  the  supply  which  is  so  dependent  on  the  action  of  these 
entrepreneurs  of  sufficient  volume  to  make  its  withdrawal  from  the 
market  significant  ?  The  correct  answer  is  surely  an  affirmative  one. 
Another  way  of  maintaining  the  proposition  that  profit  is  not  a 
true  cost  is  to  say  that,  although  some  entrepreneurs  may  earn 
profits,  the  marginal  ones  commonly  do  not ;  and  since  it  is  marginal 
cost  in  which  we  are  interested,  this  shuts  profits  out  of  costs  alto- 
gether. The  real  ground  for  this  contention  is  that  there  are  always 
producers  who  are  hardly  able  even  to  cover  their  cost  of  production, 
who  go  on  year  after  year  running  more  and  more  behind,  gradually 
using  up  their  capital ;  and  because  their  cost  is  the  greatest  of  all 
— so  great  as  to  deprive  them  of  any  profits — the  objectors  in  ques- 
tion look  on  these  producers  as  the  real  marginal  ones.  The  answer 
to  this  objection  is  that  the  persons  in  question  are  not  true  marginal 
producers.  The  true  marginal  producer  of  any  service  or  com- 
modity is  the  man  -who  would  first  quit  production  should  price 
fall;  like  the  marginal  seller  (page  276),  he  is  the  producer  whose 
presence  is  conditioned  on  the  appearance  of  the  marginal  price. 
Now  this  plainly  has  no  application  to  the  class  of  persons  described 
above.  They  are  not  brought  into  the  market  by  the  marginal 
price;  they  will  not  drop  out  of  the  market  should  the  price  fall 
still  lower.  They  will  continue  to  produce  because  they  have  no 
alternative.  They  are  perhaps  too  old  to  change  to  some  other 
employment, — hence  keep  on  for  the  opportunity  to  employ  them- 
selves, gradually  consuming  the  little  capital  which  they  have  in  the 
business. 


570  PRINCIPLES  OF  ECONOMICS 

Note  5 

A  special  exception  to  the  statement  that  rent  is  usually  a  part 
of  the  cost  which  determines  the  normal  supply  price  may  arise  in 
this  way.  As  indicated  in  the  text,  the  reason  we  usually  have  to 
include  rent  is  that  the  entrepreneur  is  driven  to  pay  that  rent 
because  of  the  competition  of  persons  who  wish  the  use  of  the  land 
for  other  purposes :  that  is,  rent  is  what  is  called  an  opportunity 
cost.  But  cases  arise  in  which  the  entrepreneur  is  compelled  to  pay 
a  certain  amount  of  rent  for  a  particular  piece  of  land,  not  because 
it  is  wanted  in  some  other  industry, — for  some  other  purpose, — but 
only  because  it  is  wanted  by  other  producers  in  the  same  industry. 
Thus,  let  us  suppose  that  a  given  piece  of  land  is  wanted  for  a  par- 
ticular purpose  in  which  its  use  would  be  worth  $1,000  a  year ;  while 
for  the  best  of  all  other  purposes  its  use  would  be  worth  only  $800 
a  year.  In  such  a  case,  rent  forms  no  part  of  the  cost  of  the  product, 
— the  cost  which  determines  the  supply  price.  The  tenant  has  to 
pay  $1,000  for  the  right  to  use  this  piece,  not  because  it  would 
otherwise  be  devoted  to  raising  some  other  product,  but  because,  in 
being  used  to  raise  this  product,  it  gives  off  a  surplus  of  $1,000,  and 
the  competition  of  other  producers  of  this  same  product  compels 
him  to  turn  over  that  surplus  to  the  landowner.  When  in  doubt 
whether  or  not  to  consider  rent  in  a  particular  case  a  cost,  the  simple 
test  is  this:  Is  the  tenant  driven  to  pay  the  rent  he  does  pay 
through  the  competition  of  producers  in  other  fields  or  through  that 
of  producers  in  his  own  field.  In  the  former  case,  rent  is  a  cost ;  in 
the  latter  it  is  not. 

Note  6 

The  untenable  character  of  the  doctrine  that  each  product  has 
its  price  fixed  by  its  own  marginal  utility  solely,  is  easily  shown.  On 
such  a  theory,  the  hypothetical  case  treated  on  page  389  would  give 
the  results  represented  in  the  accompanying  diagram  (Fig.  i).  The 
marginal  significance  of  Px  being  $120,  would  make  its  price  $120, 
which  would  make  the  price  of  the  12  L's  entering  into  it  $120, 
which  would  make  the  price  of  I  L  $10;  so  the  marginal  significance 
of  Po  being  $80,  would  make  its  price  $80,  which  would  make  the 


EXPLANATORY  NOTES 


571 


IP1 

$I20<  

M 

S 

P! 

$120 

IP, 

$ 

8(X  

M 

S 

P2 

$ 

80 

I  PS 

$ 

48*  — 

M 

S 

Pa 

$ 

48 

IP. 

$ 

24<  

M 

S 

P4 

$ 

24 

I  P5 

$ 

I2<  

M 

S 

P5 

$ 

12 

IP. 

$ 

4<  

M 

S 

P6 

$ 

4 

12  L's    $I2CK 

10  L's  $  8o< 

8  L's-$  48* 

6  L's  $  24< 

4  L's  $  I2< 

2  L's  $    4< 

Figure  I. 


price  of  the  10  L's  entering  into  it  $80,  which  would  make  the  price 
of  each  L  entering  into  it  $8 ;  and  so  on.  But  obviously,  this  result 
would  be  impossible;  we  should  have  in  the  same  market  at  the. 
same  time,  6  different  prices,  $10,  $8,  $6,  $4,  $3,  and  $2,  for  the  same 
commodity,  I  L. 

Note  7 

The  theory  as  to  the  process  of  final  price  determination  brought 
out  on  page  390  is  in  a  general  way  that  of  the  Austrian  school.  It 
may  be  represented  in  schematic  form  by  the  diagram  in  Figure  2. 


Stock") 
oi    L 

L'sf 

Money  Value  of 
Cost  Goods 

Price  of 
Products 

f  Significance 

G1  Schedule  of 
P,  P2,  P,,  P<-  P,,  PC 

Marg.  Significance^ 
of  Products 

12  L's  =$24.  

-*•  IP,  =$24. 

MSP,   =    $120.*- 

— 

10L's=  20.  

-*-IP2=  20. 

MSP2  =       80.* 

/ 

8L's=   16.  

—  IP3=   16. 

MSP3  =        48.* 

*   / 

6L's=   12.  

—  IP4=   12. 

MSP4  =       24.* 

-_/ 

4L's=     8.  

-*•  lp5  =     8. 

MSP5  =        12.*- 

IL=$2.*-2L's  =     4.-  — 
V 

—  IP,-     4.- 

•  ^MSP6  =         4. 

fOut-1  f  fSig.l 

p;«Jl'i«j 

Figure  2.     Austrian  Theory 

In  this  diagram,  L's  are  supposed  to  represent  the  single  primary 
factor  or  cost  good,  while  Px,  P2,  P3,  etc.,  represent  the  different 
products  arranged  in  the  order  of  their  marginal  as  well  as  their 


572  PRINCIPLES  OF  ECONOMICS 

generic  significance  or  value.  Our  stock  of  L's  is  supposed  to  be 
such  that  we  can  fairly  satisfy  our  need  for  products  ranging  from 
P^s  down  to  P6's,  but  no  further.  The  utility  schedules  of  all  of 
these  except  P6  are  supposed  to  be  highly  inelastic,  so  that  when 
production  is  economically  carried  out  the  marginal  utility  of  Pt 
stops  at  $120,  that  of  P2  at  $80,  that  of  P3  at  $48,  and  so  on,  as 
indicated  in  the  third  column  of  the  diagram.  At  the  top  of  the 
diagram,  left  and  right,  we  have  the  two  fundamental  elements  in 
the  process  of  price  determination :  the  stock  or  output  of  L's  on 
the  one  hand,  and  the  significance  or  utility  schedule  of  products 
on  the  other.  These  are,  so  to  speak,  the  springs  from  which  flow 
all  the  forces  that  are  in  any  way  concerned  in  the  process  of  price 
determination.  The  arrows  leaving  these  two  starting  points,  going 
around  the  main  part  of  the  diagram,  and  meeting  at  the  lower  right- 
hand  corner  bring  out  the  point  that,  however  complicated  the 
processes  by  which  the  result  would  be  reached,  under  our  present 
hypothesis,  the  price-determining  forces  would  come  to  a  focus  in 
the  marginal  significance  of  the  marginal  product.  The  remainder 
of  the  diagram  shows  that,  after  equilibrium  has  been  reached,  the 
reaction  which  is  logically  first  among  the  reactions  set  up  by  the 
interaction  of  the  stock  of  L's  and  the  several  significance  schedules 
is  the  fixing  of  the  marginal  significance  of  the  marginal  product,  P6. 
That,  being  finally  fixed  at  $4,  would  cause  the  price  of  P6  to  be 
$4,  as  indicated  by  the  arrow  going  from  right  to  left  between  these 
points.  This  price  of  $4  for  P6  would,  in  turn,  make  the  money 
value  of  the  2  L's  contained  in  it  $4,  and,  so,  would  make  the  price 
of  i  L  $2.  This  price  of  $2  each  for  the  marginal  L's  would  now 
be  communicated  to  all  other  L's,  namely,  to  those  L's  which  are 
used  in  the  higher  products.  In  consequence,  the  money  value  of 
that  quantity  of  L's  which  is  used  in  each  of  the  several  products 
would  remain  as  many  times  $2  as  the  number  of  L's  used  in  pro- 
ducing said  product.  Finally,  the  money  value  thus  established  for 
the  L's  contained  in  each  product  would  be  communicated  to  the 
products  themselves ;  that  is,  to  PD,  P4,  P3,  P2,  and  Plf  as  indicated  by 
the  five  horizontal  arrows  running  from  left  to  right.  As  a  result  Px 
would  have  a  price  of  only  $24,  though  its  marginal  utility  or  sig- 
nificance was  $120;  P2  would  have  a  price  of  only  $20,  though  its 


EXPLANATORY  NOTES  573 

marginal  significance  was  $80;  and  so  on.  That  is,  for  all  these 
supra-marginal  products,  cost,  not  utility,  is  the  determining  ele- 
ment, though  more  remotely  the  decisive  thing  is  utility,  only  it  is  the 
utility  of  the  marginal  product,  determining  the  price  or  value  of 
the  primary  factor,  and,  through  it,  the  prices  of  all  supra-marginal 
products. 

Note  8 

In  explaining  the  Austrian  theory  of  final  price  determination,  it 
is  almost  impossible  to  avoid  letting  in  some  misleading  implications. 
Thus,  it  is  almost  impossible  to  avoid  giving  the  impression  that  the 
marginal  utility  of  P6  would  be  first  determined  independently  of 
everything  else;  that  this  marginal  utility  would  thereupon  determine 
the  price  of  P6  independently  of  everything  else;  that  the  price  of 
P0  thus  determined  would  then  fix  the  price  of  L's  devoted  to  its 
production  independently  of  everything  else;  and  so  on.  Now,  it  is 
surely  quite  impossible  that  anything  like  this  should  take  place. 
No  one  of  these  things,  whether  the  marginal  utility  of  the  marginal 
product  or  the  price  of  any  one  of  the  various  products  or  the  price 
of  L's,  could  be  determined  independently  of  the  determination  of 
every  other  one  of  them.  The  marginal  significance  of  P6  could 
not  be  determined  until  the  output  of  this  product  had  been  finally 
determined.  In  turn,  the  output  of  Pc  could  not  be  determined  until 
the  question  of  the  number  of  L's  available  for  this  purpose  had 
been  determined.  Again,  the  question  of  the  L's  available  for  pro- 
ducing P6's  could  not  be  determined  until  it  had  been  decided  how 
many  of  the  higher  products,  P1?  P2,  P3,  P4,  were  to  be  produced. 
Still,  again,  it  could  not  finally  be  determined  how  many  of  these 
higher  products  were  to  be  produced  until  it  was  known  what  price 
they  were  to  have  and,  therefore,  what  demand  there  would  be  for 
them.  But,  since  their  price  would  be  dependent  on  the  price  of  the 
L's  entering  into  them,  and  the  price  of  L's  would  be  dependent  on 
the  price  of  P6,  and  the  price  of  P6  would  be  dependent  on  its  mar- 
ginal utility,  we  seem  to  be  in  a  position  where  we  are  obliged  to 
say  that  nothing  could  be  determined  until  everything  else  had  been 
determined.  That  is,  we  seem  to  be  trying  to  break  into  a  com- 
pletely closed  circle.  And  this  is  of  course  true.  Nothing  could  be 


574 


PRINCIPLES  OF  ECONOMICS 


finally  determined  until  everything  else  had  been  determined.  As  in 
so  many  other  fields,  reaction  as  well  as  action  is  present  and  the 
result  must  be  influenced  by  both.  Nevertheless,  it  is  legitimate  to 
represent  the  real  order  of  causation,  when  everything  is  finally 
settled,  in  the  way  we  have  done.  When  at  last  equilibrium  would 
have  been  reached,  the  starting  point  of  this  causation — the  point 
where  the  fundamental  price-determining  forces  break  into  the  circle 
— would  be  in  the  marginal  significance  of  the  product. 


Note  9 

The  modification  of  our  diagram  made  necessary  by  the  intro- 
duction of  the  element  of  disutility  is  easily  effected.  As  before 
there  are  two  sources  from  which  are  derived  the  forces  ultimately 
determining  prices,  and  these  appear  at  the  top,  one  at  the  left,  the 


Disutility 
Schedule 
of  L's 


[Significance 
Schedule  of 


Marg.  Disutility 
of  L's 


Money  Value  of 
Cost  Goods 


12L's=$24.- 
10L's  =  20.- 
8L's=  16.- 
6L's=  12- 
4L's=  8.- 
2  L's=  4.= 


Price  of 
Products 

•IP,  =  $24. 
•IP2=  20. 
-IP3=  16. 
•IP4  =  12. 
•IP5=  8. 
:IPe=  4. 


Marg. 

Significance 
of  P's 

MSP,  =  $120.* 
MSP2=     80.* 
MSP3  =     48.* 

MSP4  = 

24.* 

MSP5  = 

12.* 

=:    MSP6  = 

4. 

rSig.l 
Sch.K 

1P6SJ 

fOut- 
Jput 

(Pis 

JL 

*MDL's=  1.10 

*MDL's=  1.20 

-MDL's=  1.35    __/ 

-MDL's=  1.50    IL=$2. 

MDL's=    2.00 

4)isutl    f    Ibem 
5ch.H*^f 
L's  J         U's 


Figure  3.     Significance-Disutility  Theory 

other  at  the  right.  The  one  at  the  left,  however,  is  different  from 
the  old  one.  This  time  it  is  the  disutility  schedule  of  the  single  pri- 
mary factor,  L,  or,  what  is  the  same  thing,  the  supply  schedule  of 
that  factor.  Again,  as  in  the  former  case,  we  have  a  process  of 
causation  which  starts  from  the  marginal  utility  or  significance  of 


EXPLANATORY  NOTES  575 

the  marginal  product,  moving  thence  to  the  price  of  that  product, 
thence  to  the  value  of  2  L's,  then  to  the  price  of  I  L.  At  this  point, 
however,  utility  or  significance  finds  itself  obliged  to  recognize  the 
influence  of  another  force,  the  disutility  of  producing  L's.  For  the 
existence  of  that  disutility  makes  it  impossible  for  equilibrium  to 
be  established  until  the  price  of  each  L  is  great  enough  to  cover  that 
disutility.  Accordingly,  we  have  this  time  in  the  lower  left-hand 
corner  a  reaction  between  the  disutility  schedule  of  L's  and  the 
demand  for  them  from  which  is  determined  the  marginal  disutility 
of  supplying  these  L's,  which  in  turn  compels  the  price  of  I  L  to 
be  what  is  needed  to  express  this  marginal  disutility.  That  is,  the 
price  of  I  L  is  $2  not  only  when  and  because  $2  is  the  marginal 
significance  of  the  marginal  product  of  L's,  but  also  when  and  be- 
cause $2  is  the  marginal  disutility  of  supplying  L's. 

Note  10 

The  point  brought  out  in  the  text — that  it  is  not  the  absolute  mag- 
nitude of  wants  but  rather  the  results  conditioned  upon  their  gratifi- 
cation which  determines  their  social  importances — seems  obvious 
enough,  yet  is  constantly  disregarded  by  not  a  few  writers.  In  con- 
sequence, it  seems  desirable  to  give  it  the  emphasis  derivable  from 
diagrammatic  presentation.  In  the  accompanying  figure,  the  open 
space  to  the  right  of  the  vertical  line  represents  the  field  of  social 
advantages  or  importances,  while  the  enclosed  space  to  the  left  of  the 
vertical  line  represents  the  field  of  individual  or  private  importances 
estimated  as  absolute  magnitudes.  The  upper  right-hand  circle 
represents  one-fifth  of  the  social  importance  of  the  contribution  of 
some  person,  Mr.  A  we  will  call  him, — the  whole  of  his  contribution 
being  assumed  to  have  an  importance  represented  by  $5,000.  The 
outer  one  of  the  two  concentric  circles  at  the  left  and  above — the 
broken-line  one — represents  some  want  of  the  man  contributing  the 
$1,000  worth  of  service,  which  want  the  subject  himself  estimates  at 
$1,000.  The  inner  one  of  these  two  concentric  circles — the  con- 
tinuous-line one — represents  the  real  or  absolute  magnitude  of  the 
want  in  question  which  is  assumed  to  be  only  $100.  The  heavy  line 
connecting  the  $1,000  circle  of  social  importance  with  the  $1,000 


5/6 


PRINCIPLES  OF  ECONOMICS 


circle  of  individual  importance  as  estimated  by  the  individual  im- 
mediately interested  signifies  that  the  getting  of  the  $1,000  worth  of 
service,  represented  by  the  upper  right-hand  circle,  is  conditioned 
upon  giving  the  man  who  contributes  that  service  the  volume  of  grati- 
fication represented  by  the  outer  one  of  the  two  concentric  circles 
named.  This  brings  out  the  relation  among  the  wants  and  contribu- 
tions of  Mr.  A.  Of  the  lower  circles,  the  right-hand  one  shows  the 


INDIVIDUAL 


GENERAL 

SERVICES 
$1,000 


o 


Figure  4.    Social  versus  Individual  Importance 

social  importance  of  one-fifth  of  the  service  of  a  second  person,  Mr. 
B.  The  inner  one  of  the  two  lower  left-hand  circles — the  broken- 
line  one — represents  the  estimate  which  B,  in  view  of  his  money 
income,  puts  upon  a  certain  want  of  his,  while  the  absolute  magni- 
tude of  that  want  is  represented  by  the  larger  outer  circle — the 
continuous-line  one — with  the  $1,000  mark.  The  heavy  line  con- 
necting the  $100  circle  of  social  advantage  with  the  $100  circle  of 
individual  want — the  dotted  one — signifies  that  the  forthcoming  of 
said  social  advantage  is  conditioned  on  the  satisfying  of  this  want 


EXPLANATORY  NOTES  577 

only  so  far  as  $100  will  do  it.  Under  these  conditions,  it  is  mani- 
fest that  if  A  and  B  come  into  competition  for  the  disposal  of  social 
resources,  A's  want  which  has  an  effective  magnitude  of  $1,000, 
though  having  an  absolute  magnitude  of  only  $100,  will  outweigh 
the  want  of  B  which  has  an  effective  magnitude  of  only  $100  though 
its  real  or  absolute  magnitude  is  represented  by  $1,000.  Now,  to 
the  unthinking,  all  this  looks  very  unreasonable,  not  to  say  very 
wicked.  The  trifling  want  is  treated  as  if  it  were  the  great  one ;  the 
great  want  as  if  it  were  the  trifling  one.  But  there  is,  broadly  speak- 
ing, nothing  in  this  view  of  the  matter.  The  social  importances  in- 
volved are  represented  by  the  circles  to  the  right  of  the  line, — the 
circles  located  in  the  social  field.  It  is  on  these  that  our  eyes  should 
be  fixed.  A's  contribution  has  a  social  importance  of  $1,000;  the 
supplying  of  that  contribution  is  conditioned  on  the  gratification  of  a 
want  which  A  estimates  at  $1,000;  said  want,  therefore,  has  a  social 
importance  of  $1,000.  B's  contribution  on  the  other  hand,  has  a 
social  importance  of  only  $100 ;  the  supplying  of  that  contribution  is 
conditioned  on  the  satisfying  of  a  want  which  is  formally  expressed 
by  only  $100;  said  want,  therefore,  has  a  social  importance  of  onlf 
$100. 


y 


r4t 


.Jj 


i 


> 


c*/>- 


I 


/     o  - 


Date  Due 


JUN 

7  1972 

HIM  Q 

1079  <y 

JU.N  0 

\JIL    t 

SOUTHERN  REG  ONAL  L  BRARY  FACILITY 

II  II  I  III  Illl  II  III  I  III  1  1 

001343319    8 

., 

Library  Bureau  Cat.  No.  1137 

